U.S. Tax Law and Estates and Trusts

An estate is established on the date of death. Your tax professional should obtain an EIN for the estate and file an estate tax return form 1041: but not so quick, if a pre-tax funded investment account such as an IRA is part of the estate, some technical tax planning should first be considered in order to reduce a tax bill that will probably be substantial. Such planning should include a serious look into strategic options such as choosing to liquidate the account over five (5) years or an election for a non-calendar tax year.

Generally, it is true that an inheritance is not taxed to the heir or beneficiary; however, there are important exceptions. Avoid being liable for taxes by giving due attention to federal and state tax issues, even for smaller estates. While most understand that an "estate tax" is levied on an estate over a certain value (sometimes referred to as the "death tax"), many people do not think of the ordinary "income" tax liabilities of an estate-especially those handling smaller estates.



One common surprise is that estates consisting of an account funded by pre-tax dollars (such as an IRA for which no beneficiary was designated) will most likely have a substantial tax liability. In such cases, the entire IRA becomes part of the estate: if the IRA is cashed out and distributed to the heirs, a tax will often be applied at the highest rate as ordinary income. In 2014, if the account is worth $100,000.00, the tax would be about $40,000.00. If this tax is not paid by the estate, the IRS will demand payment from the heirs that received this money.

Another trap for which to watch revolves around the sale of stock held in the estate. If stock is liquidated before it is distributed, the increase in value of the stock, if any, that occurred during the period from the date of death until it is liquidated is taxable to the estate. If a beneficiary prefers to receive the cash value as opposed to the stock itself, it may be better to first transfer the stock to the beneficiary and then the beneficiary can apply tax-reduction strategies that may not be available to an estate.

Probate court in many states require that both federal and state income tax returns be filed-the final 1040 for the year in which the death occurred and a final 1041 for the estate. Do not rush into filing these tax returns without a tax professional's assistance and without obtaining an Estate Tax Closing Letter from the IRS and other applicable tax agencies, otherwise the IRS may be looking for payment from the executor, administrator, trustee, heirs and beneficiaries.

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