What Income Taxes?

Most attorneys know that there is a Federal Estate Tax on estates of a certain size. Most of those attorneys know that there is also an Illinois Estate Tax that goes hand-in-hand with the Federal tax. I am constantly surprised, however, by the number of attorneys who do not know that estates which may not need to file estate death tax returns may have to file Fiduciary income tax returns and perhaps pay taxes.

I consult an accountant on every estate. That is an effective way to address all fiduciary income tax questions in connection with estates. With that in mind, the following information is meant to give only a brief general overview of estate income taxes. For any specific questions, please consult a knowledgeable accountant.

All income earned in a tax year on an asset prior to the date of death goes on the decedent’s final Forms 1040. Income earned after that date belongs to the estate. If an estate has more than $600.00 in gross income in its tax year, it is required to file fiduciary income tax returns. After figuring income, the estate then takes its deductions. One important difference between individuals and estates is that estates get to deduct fees paid, including to attorneys, accountants, and estate representatives. Deductions are subtracted from income, and the net income or loss is determined. If nothing further is done at that point and if there is net income, the estate will have to pay tax on that income. Estate income tax brackets are narrower than individual income tax brackets, and the highest tax rates are reached at very low numbers. That means that if income is kept in an estate past the end of its tax year, the taxes may be very substantial.

How can those high tax rates be avoided? The estate gets one more important deduction. It is entitled to deduct sums distributed to the beneficiaries of an estate, which is a way to reduce the taxable income of an estate. For example, if the estate’s net income is $10,000.00 and it distributes $10,000.00, its net income is $0, and no tax will be paid by the estate.

If the estate has a net loss instead of net income, that loss gets passed through to the beneficiaries, and they may take it as a miscellaneous deduction on Schedule A. When the estate files fiduciary income tax returns, it reports all of the income and deductions and reports the distribution to each beneficiary on Forms K-1. The beneficiaries then report the “income” or loss from the estate on their individual tax returns.

1. Most assets as of the date of death do not carry any income tax liability with them. Exceptions to that rule are tax-deferred assets such as IRA’s, 401(k) plans, etc. Where income tax was deferred initially, the deferred amount is usually treated as income when it is received by the estate.

2. The estate’s income tax rate for capital gains in an estate is the same for estates as for individuals.

3. There is one other useful characteristic of estate Fiduciary income taxes. The estate is entitled to elect a fiscal year rather than a calendar year. The end of the fiscal year must be at the end of a calendar month and may not go more than 12 months past the date of death of the decedent. An estate may be able to delay distribution of income by electing a fiscal year that goes past December 31. On the other hand, the estate may elect either a calendar year or a short fiscal year in order to pass through to the beneficiaries a net loss in the current tax year. Timing of distributions and selection of a fiscal year can affect from whom or what entity the income tax will be paid. By skillful planning, any tax to be paid can end up being paid by the taxpayers with the lowest tax rates.

4. Income taxation of trusts is similar to estates, except that the income threshold is only $100, not $600. A trust also must be administered on a calendar year basis, not a fiscal year.

5. Expenses to be deducted must be paid during the estate’s tax year. However, distributions can be made within 65 days after the end of the estate’s tax year.

6. It is most important to get a competent accountant involved at the beginning of each estate and to work together all along the way. Fiduciary income tax is a somewhat complicated area of taxes, and not all accountants are familiar with the area. There are usually numerous situations that impact on taxes, and the accountants know them. There are many opportunities to blow time periods or make other tax errors. With a knowledgeable accountant on board, that risk can be eliminated.