Are there income tax issues in settling an estate?

By Attorney Truman Scarborough

When a person dies, the successor trustee of a trust and the personal representative (executor) of a probate estate have various responsibilities to the court, the beneficiaries, the creditors, and the Internal Revenue Service. What is required of a successor trustee and a personal representative can be substantially different. For example, a successor trustee should have no involvement with the courts, unlike the personal representative of a probate estate. The specific obligations to creditors and beneficiaries also vary depending on whether there is a trust or probate estate.

In an earlier article, we examined who is responsible for a decedent’s bills. With this discussion, we look at obligations to the Internal Revenue Service for income taxes. While a trustee’s and personal representative’s responsibilities to the courts, creditors, and beneficiaries vary considerably, their responsibilities for income tax are similar.

There is also a responsibility for estate taxes. However, since federal estate taxes only become an issue when an estate is over $5,450,000 in value, the following discussion is limited to income taxes, which apply to all estates regardless of value. There are other related tax topics that are beyond the scope of this article including: “stepped up basis” for appreciated assets; which type of beneficiaries bear the burden of paying the taxes; state estate/inheritance taxes; IRA distributions; and, income tax issues for the beneficiaries.

When someone passes away, a tax identification number (EIN) must be obtained from the IRS for the probate estate and/or trust. The EIN is like a social security number for artificial legal entities, such as corporations, irrevocable trusts, and probate estates. Financial institutions need this number to report income since they can no longer report income under the decedent’s social security number. With a revocable trust, while the creator is living, income is reported under the social security number. But when the creator of the trust dies, the trust becomes irrevocable and income must be reported using an EIN.

Annual income is reported on 1099s. For the portion of the year when the decedent was living, the 1099s will show the decedent’s social security number. Income earned after the decedent passed away is reported on 1099s using the EIN.

A 1041 fiduciary income tax return is filed for income received under the EIN. There is a substantially higher tax rate on a 1041 than on an individual 1040 return. To avoid the higher tax rate, income can be distributed to the beneficiaries. These distributions are shown on Schedule K-1s so the income tax can be paid by individual beneficiaries at the lower rate.

A personal representative and/or successor trustee is required to file these tax returns and can be personally liable to IRS for the decedent’s taxes. This may include taxes the decedent failed to pay in prior years. The accountant who is preparing the returns may suggest filing:

 

  • IRS Form 56 (Notice Concerning Fiduciary Relationship): This is filed when the duties are first assumed and then again when the duties are completed.

 

  • IRS Form 5495 (Request for Discharge from Personal Liability): IRS has three years to review returns to determine if additional taxes are due. When Form 5495 is filed, the review takes place in nine months at which time the personal representative and/or trustee will be released from further personal liability.

 

 

For further information, you may be interested in Attorney Truman Scarborough’s Booklet on Estate Planning in Florida. It is available without charge or obligation by calling (321) 267 – 4770. His office is located at 239 Harrison Street, Titusville, Florida.

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