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Tax Considerations When a Loved One Passes Away (Part 2)



A financially comfortable loved one has passed away. In this year of seemingly endless bad news, that’s not an uncommon situation—sad but true. The now-deceased loved one may have been single or married and may have been a relative or not. In any case, you’ve stepped up to the plate and taken on the challenging job of acting as executor for the deceased person’s estate. Good for you. But it can be a lot of work, including handling important tax matters. This article is the second of our three-part series on what you, as the executor, need to know about the most important federal tax issues.


Note. There may be state tax issues too, but those are beyond the scope of our analysis here.


The Executor’s Role


When a loved one passes away, someone must handle the resulting financial fallout, including the tax issues. That person may be identified in the “decedent’s” (deceased individual’s) will as the executor of the decedent’s estate. If there is no will, the probate court will appoint an administrator. In either case, it’s often the surviving spouse or another family member who takes on the responsibility. In this article, we will refer to that person as the “executor.” That would be you! Your role as the executor is to identify the estate’s assets, pay off its debts, and distribute the remainder to the rightful heirs and beneficiaries. You are also responsible for filing any necessary tax returns and arranging to pay any taxes. We covered some of the most important tax issues in Part 1 of our analysis. This article presents the rest of the story. Here goes.


Choose Tax Treatment for Decedent’s Medical Expenses


Pay extra attention to the decedent’s medical expenses. If uninsured expenses were incurred but not paid before death, you (as the executor) must make a potentially important choice about how those expenses are treated for federal tax purposes. Along with any medical expenses that have already been paid in the year of death, the executor (you) can choose to deduct as-yet-unpaid medical expenses on the decedent’s final Form 1040, to the extent the combined paid and unpaid expenses exceed 7.5 percent of adjusted gross income (AGI)—assuming the decedent’s final Form 1040 itemizes deductions. To take advantage of this special itemized deduction privilege for unpaid medical expenses, you must pay the expenses out of the decedent’s estate during the one-year period beginning with the day after the date of the decedent’s death.


Planning point. Under this special rule, you


  • avoid the cash-basis taxpayer rule, which requires you to pay the expense before you can deduct it ;and

  • likely have more than a year of expenses compared with what you would have had on a cash basis, making it more likely that you can exceed the 7.5 percent floor.

Alternatively, in the relatively unlikely event that the estate is subject to the federal estate tax, you (as the executor)can choose to deduct unpaid medical expenses on the decedent’s federal estate tax return rather than on the decedent’s final Form 1040. But when no federal estate tax is owed, this is not an option.


The federal estate tax exemption for someone who died in 2020 is a whopping $11.58 million, so only a few estates of individuals who die in 2020 will owe any federal estate tax.


Planning point. When federal estate tax is owed, deducting unpaid medical expenses on the federal estate tax return is usually the tax-smart option. That’s because the federal estate tax rate is 40 percent whereas the decedent’s final federal income tax rate could be as low as 10 percent. Also, you can deduct the full amount of unpaid medical expenses on the estate tax return, not just the excess over the 7.5 percent of AGI threshold.


File Estate’s Federal Income Tax Return (Form 1041)


You, as the executor, are also responsible for the estate’s federal income tax return. After the decedent has passed away, income generated by his or her holdings now belongs to the estate, and that income does not escape the clutches of good ol’ Uncle Sam. The estate’s initial federal income tax year begins immediately after the decedent’s death. The tax year-end can be December 31 or the end of any other month that results in an initial tax period of 12 months or less.


You won’t need to file Form 1041 when all the decedent’s income-producing assets bypass probate and go straight to the surviving spouse or other heirs by contract or by operation of law. For example, this is what happens with

  • real property that is owned by joint tenants with right of survivorship,

  • qualified retirement plan accounts and IRAs that have designated account beneficiaries, and

  • life insurance death benefits that are paid directly to designated policy beneficiaries.

File Estate’s Federal Estate Tax Return (Form 706)


File the federal estate tax return on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. Assuming the decedent did not make any sizable gifts before passing away, no federal estate tax will be due and no Form 706 will be required, unless the estate is valued for federal estate tax purposes at more than$11.58 million for a person who died in 2020.


Sizable gifts mean those in excess of

  • $15,000 to a single gift recipient in a single year, for gifts in 2018-2020;

  • $14,000 for gifts in 2013-2017;

  • $13,000 for 2009-2012;

  • $12,000 for 2006-2008;

  • $11,000 for 2002-2005; and

  • $10,000 for 2001 and earlier.

If such sizable gifts were made, the excess over the applicable threshold for the year of the gift is added back to the estate to see whether the estate tax exemption ($11.58 million for 2020) is surpassed. If it is, there is a 40percent federal estate tax on the excess. Form 706 is due nine months after the decedent’s date of death, but you can extend the filing deadline for up to six months by submitting Form 4768 to the IRS.


Planning point. If you choose to extend, send Form 4768 by certified mail, return receipt requested. Better to be safe than sorry.


The Unlimited Marital Deduction


If the decedent’s surviving spouse is a U.S. citizen, an unlimited amount can pass to the surviving spouse free of any current federal estate tax. This is thanks to the so-called unlimited marital deduction privilege. The unlimited marital deduction, in conjunction with the generous federal estate tax exemption for 2020, can allow a relatively large estate to avoid any current federal estate tax liability.


Life Insurance Proceeds


While life insurance proceeds are generally free of any federal income tax, they are usually included in the decedent’s estate for federal estate tax purposes, even though the money may go directly to designated policy beneficiaries. An exception to this general rule can apply when the policy beneficiary is the surviving spouse. Here’s the reason: assets inherited by a surviving spouse (including life insurance payouts) are not included in the decedent’s estate for federal estate tax purposes when the surviving spouse is a U.S. citizen. This is thanks to the aforementioned unlimited marital deduction privilege.


Filing Form 706 Solely to Make the Portability Election


While you may think no Form 706 is necessary because no federal estate tax is owed, you may be well advised to think again.


Reason. Filing Form 706 is necessary to make the so-called portability election that allows you, as the executor, to pass the decedent’s unused unified federal estate and gift tax exemption to the surviving spouse. The portability privilege can be a really big tax-saving deal for well-off married couples.


In future years, who knows what the allowable unified federal estate and gift tax exemption will be—or if there will even be one. Nobody knows what the impact of making an earlier portability election will be. But making the election cannot possibly hurt, and it might pay off big-time in the future. So, please make the election in the case of a well-off married couple. That requires filing Form 706.


If you file Form 706 solely to make the portability election, an extended filing deadline applies. The deadline is on or before the second anniversary of the decedent’s date of death.

And you have to complete only a portion of the Form 706. Even so, preparing Form 706 is no picnic, and nobody would blame you for hiring a tax pro to do it.


Take Care of Other Tax-Related Details


If you, as the executor, will be filing Form 1041 and/or Form 706, you’ll need to get the estate a federal employer identification number (EIN). This is analogous to an individual’s Social Security number. Apply for an EIN with FormSS-4 (Application for Employer Identification Number).


Next, file Form 56 (Notice Concerning Fiduciary Relationship) to notify the IRS that you, as the executor, will be acting on behalf of the estate regarding federal tax matters. Filing Form 56 ensures that you will receive any notices sent out by the IRS (we hope and trust).


Next, open a checking account in the name of the estate, with some funds transferred from the decedent’s account(s). As the executor, you have the legal power to do this. But make sure you have the estate’s EIN in hand, because the bank will ask for it. Then use the new account to accept deposits from income earned by the estate and to pay the estate’s expenses such as outstanding bills, funeral and medical expenses, and (of course) taxes. Unfortunately, after you have taken care of all the above, your work still might not be done. You also may be responsible for state income tax returns and perhaps a state death tax return as well.


Takeaways


The decedent’s medical expenses provide you with planning opportunities to

  • deduct as itemized deductions (subject to the 7.5 percent floor) not only the medical expenses incurred during the taxable year of death, but also those unpaid at the date of death but paid within one year of death; or

  • deduct in full (no floor) the medical expenses paid after the date of death against the federal estate tax.

You, as the executor, may need to file

  • the decedent’s final Form 1040,

  • the estate’s Form 1041 income tax return, and

  • the estate’s Form 706.

You won’t need to file Form 1041 when all the decedent’s income-producing assets bypass probate and go straight to the surviving spouse or other heirs by contract or by operation of law—assets such as

  • real property that is owned by joint tenants with right of survivorship,

  • qualified retirement plan accounts and IRAs that have designated account beneficiaries, and

  • life insurance death benefits that are paid directly to designated policy beneficiaries.

If the estate is valued at $11.58 million or less and the decedent did not make any sizable gifts before death, you don’t have to file Form 706. But even if you don’t have to file Form 706, you may want to file it anyway to preserve the portability election.


The important federal tax considerations explained in this article and in the Part 1 article can apply when a loved when passes away, so pay close attention—especially if you are the executor.

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