How is a the Income of a Decedent’s Estate Taxed?

Many people know that the estate tax applies only to estates of several million dollars, but that doesn’t mean that an estate has no tax obligations. An estate must file an income tax return and, depending on the timing of distributions, pay income tax. Typical items of taxable income include interest, dividends, and capital gains. An estate reports income and deductions similarly to a complex trust on IRS Form 1041. However, there are some important differences, such as choice of fiscal year, quarterly estimated tax payments, and rental real estate losses. Often a person dies with assets held in a revocable trust and some or all of the trust becomes irrevocable upon death. Typically this results in the creation at death of two taxable entities, the decedent’s estate and the irrevocable trust. If proper procedures are followed, income tax law allows these two entities to be combined for income tax return purposes. This usually results in more favorable tax rules, and, since only one income tax return is required per year, saves on professional tax preparation fees.

Trust Modification – Court-Approved

In a recent private letter ruling, the IRS determined that a court-approved modification of a revocable trust created by a decedent and spouse doesn’t provide the surviving spouse with a “general power of appointment”. Therefore, the value of assets in by-pass trust won't be included in surviving spouse's gross estate. Trust assets were to be divided upon death of first spouse among by-pass trust, marital trust, and survivor's trust. (PLR 201002013)

Beginning of Estate for Tax Purposes

Although a decedent’s estate is created at the moment of death, its income tax year begins the next day. The timing of appointment of personal representative or administrator or executor has no effect on the beginning of the estate tax year. The date of death, therefore, is the last day of the decedent’s personal income tax year. Income received after the date of death is generally reportable on the estate income tax return using the estate’s tax ID#, not the decedent’s personal income tax return and Social Security number. This is true even though many payers issue tax forms, such as 1099’s and W-2’s, in the name and tax ID# of the decedent.

Tax News Roundup 22 Dec 2008

Rental real estate: Where taxpayers showed good faith, IRS granted extension to treat all their interests in rental real estate as single rental real estate activity (PLR 200851001). This is good news for taxpayers, but an expensive and risky way to go about it. Better to just make the election on the tax return.

S-Corporation: IRS allowed continued treatment as an S-corporation even though stock was issued to stock to LLC/ineligible shareholder, ruling that the action was inadvertent (PLR 200851008).

S-Corporation: IRS did not allow a corporation to re-elect S-corporation status before the 5-year post-termination period was up (PLR 200851003).

S-Corporation: IRS continuing to allow late S-corporation elections where reasonable cause can be shown (PLR 200851015; PLR 200851022).

Trust: Trust disregarded and self-employment tax imposed on distributions where trusts lacked economic substance (Alfred J. Olsen, et ux. v. Commissioner, TC Memo 2008-275).

Estate: Estate allowed to deduct attorney's fees for estate administration, although attorney's papers were sloppy and record was otherwise “thin” (Estate of Thelma G. Hurford v. Commissioner, TC Memo 2008-278.