By Fredrick P. Niemann, Esq. of Hanlon Niemann, a Freehold, NJ Estate Administration and Probate Attorney
Once appointed by the County Surrogate, the executor of an estate has many strategic decisions to make that may impact the tax liability of both the estate and the estate’s beneficiaries. Once made, many of those decisions become irrevocable or difficult to reverse. The following is a brief overview of some of the major decisions involved in filing a decedent’s final federal income-tax return (Form 1040), the estate’s federal income-tax return (Form 1041), and the federal estate-tax return (Form 706).
Decedent’s Final Return
Internal Revenue Code Section 6012(b)(1) charges the executor (or other person entrusted with the decedent’s property) with the responsibility for filing the final income tax return for the decedent. Because most individual taxpayers file on a calendar-year basis, the final tax year will usually cover the period from January 1 to the date of death. For a calendar-year taxpayer, the return is due on April 15th of the following year. An automatic six-month extension may be obtained by filing Form 4868 and paying any estimated tax due with the extension.
If the decedent was married at the time of his death, the executor can generally file a joint return with the decedent’s surviving spouse, provided the spouse has not remarried before the end of the calendar year. If no executor or estate representative has been appointed, the surviving spouse may file the joint return on his or her own.
Generally, married couples will obtain a better result by filing jointly rather than separately. In addition to the applicable tax brackets, there may be other reasons for filing jointly. For example, the decedent may have capital gain losses that cannot be carried over to the estate income-tax return. The executor may want to file jointly if doing so would allow the losses to be used against capital gains realized by the surviving spouse. On the other hand, by filing jointly, the executor becomes potentially liable with the surviving spouse for all taxes and penalties for the final tax year. Each case will present a different set of facts for this analysis. It also raises some ethical and fiduciary conflicts if the executor declines to join in on the tax return with the surviving spouse.
Medical Expenses. Unpaid medical expenses may be deducted as a debt on the decedent’s estate-tax return or deducted as a medical expense in the year incurred if paid within one year of the date of death. Generally, if the estate is nontaxable, taking the deduction on the final return will result in the greatest tax savings. However, where the estate is using both the applicable exclusion amount and the marital deduction to eliminate estate taxes, the executor’s decision regarding where to deduct the medical expenses may affect each beneficiary differently.
Estate Income-tax Return
Because the decedent’s final tax year ends on the date of death, the estate’s first tax year begins the following day and may be for a period of less than one year.
The executor is required to file an income-tax return for the estate for each tax year in which the estate has gross income of $600 or more or if any beneficiary is a nonresident alien.
Calendar vs. Fiscal Year. Initially, the choice of which year to select to file is a consideration. The taxable year is chosen on the first return. Unlike trusts, which must use a calendar year as a taxable year, estates may choose either a calendar or fiscal year. A fiscal year may be for a 12-month period that ends on the last day of any month other than December.
In many cases, the executor will want to choose a fiscal year that ends after the close of a beneficiary’s taxable year. The reason for this is that a beneficiary is deemed to receive his or her share of the estate’s income on the last day of the estate’s fiscal year, even if the distribution was actually made earlier. Let’s see how this works.
Illustration. Decedent dies on May 15 of Year 1. The tax year of the estate’s sole beneficiary is the calendar year. By choosing a fiscal year that ends on January 31, the executor assures that any income distributed during Year 1 will not be included in the beneficiary’s income until Year 2. Thus, you can postpone the effective date when the tax is owed.
If the decedent had a revocable living trust that became irrevocable at death, an election may be made to treat the trust as part of the decedent’s estate. If the estate has adopted a fiscal year, making the election would allow that year to be used for reporting the trust’s income.
Administration Expenses and Losses. A constant question comes up concerning the decedent’s final debts and expenses. Generally, an executor can choose to either deduct estate administration expenses and losses on either the estate’s income-tax return or the corresponding estate-tax return. If the estate is non-taxable, the executor will typically want to take all available deductions on the estate’s income-tax return. However, if the value of the gross estate exceeds the applicable exclusion amount ($675,000), different considerations come to play and the analysis becomes more involved. The executor will always want to get the most value dollar for dollar on the treatment of deductions.
The Estate-tax Return
There are several important decisions an executor may need to make in connection with the estate-tax return.
Portability Election. Under the Federal Tax Code, if the estate of a married decedent is not greater than $5,340,000 as of 2014 (it’s $5,430,000 in 2015) which under federal law triggers the filing of a federal estate-tax return, the executor may still want to preserve the unused exclusion amount commonly referred to as the “DSUE” for the surviving spouse. The tax code offers an election to the estate of any decedent who was a resident or citizen of the United States on the date of his or her death who is survived by a spouse. The executor must make this election on the estate-tax return.
Executors who fail to file the federal estate tax return (because the applicable exclusion renders the estate exempt from filing) but would like to make the portability election anyway may still be able to do so. Hence, the executor of the estate may file a complete and properly prepared Form 706 for the estate within nine (9) months of date of death, plus any applicable extensions.
Alternate Valuation Date. This concept is quite valuable to understand. Generally, the assets of an estate are valued as of the decedent’s date of death. However, the executor may elect to have estate assets valued as of the date six months later or even sooner if the assets are sold, exchanged, or otherwise disposed of prior to six (6) months. To make the election, the executor must demonstrate that the election will decrease both the value of the gross estate and the amount of the estate and generation-skipping transfer taxes. Before making this election, as the executor, you should consider the effect the election will have on other available elections. In some cases, the beneficiaries may be better off financially by keeping the higher date-of-death value because it will reduce subsequent capital gains and/or increase depreciation deductions because of the higher basis utilized for income-tax purposes.
Disclaimers. The use of disclaimers is an important tool when evaluating options in estate administration. While ultimately it is the beneficiary who must elect to make a “qualified disclaimer”, the executor will often be included in the decision and whether such election is best for the estate and the beneficiary. Timing is critical here because disclaimers must be made within nine months of the date of death. This election deadline is unrelated to the filing of the federal estate-tax return. It is based on the date of death so any extension of time to file the estate-tax return will not extend the period for making the disclaimer.
Proper administration of an estate requires the executor to make a number of strategic decisions — both tax related and otherwise — in a timely manner. Careful planning is essential for successfully fulfilling one’s fiduciary duties to the estate and the estate’s beneficiaries.
To discuss your NJ estate administration or probate matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at firstname.lastname@example.org. Please ask us about our video conferencing consultations if you are unable to come to our office.