Decedents and the Estate Tax: Updates Following 2018 Tax Reform
Working as an accountant, tax preparer, enrolled agent, or tax attorney can be both rewarding and challenging. And sometimes, the challenges that the work presents might surprise you. When you think of a difficult task in the accounting world, you probably picture a big stack of unorganized receipts, income statements, invoices, and other documents that a client drops off at your office. Maybe it’s enough paperwork to fill up a whole filing cabinet, and they expect you to do just that: go through it, organize it, file it, and understand it. Some clients are more organized than others and dealing with these sorts of messy situations is part and parcel of the job. Other times, though, the challenges of an accounting job are more subtle and interpersonal. If one of your clients approaches you with a question about decedents and the estate tax, they may still be coping with the loss of a loved one. The reality is that having to deal with something as complex as the tax code isn’t what most people want to be doing in such a situation. While the rules and requirements laid out by the IRS may be crystal clear to you (more often than not, anyway), they can be incredibly confusing and frustrating for the average client to sift through. When a client is already dealing with the emotional and personal stresses associated with losing a family member, they’ll likely need (and possibly expect) you to communicate clearly, work diligently, and put together their form 1041 with minimal fuss.
Unfortunately, preparing an estate income tax return can be quite complicated. And while the rules surrounding decedents and the estate tax have changed minimally over the past couple of decades, the recent tax reform legislation includes alterations to how you’ll need to file your client’s estate tax form 1041. Considering what a sensitive topic this aspect of your business can be to begin with, it’s important to bring yourself up to speed and ensure that you fully understand the new changes to the existing tax code. The last thing you want is to appear uninformed or unsure in front of a client, particularly when they’re already likely to be dealing with a significant amount of personal and emotional turmoil. Considering the sheer complexity of both the Tax Cuts and Jobs Act (an 1,100+ page bill filled with sweeping tax reform legislation) and the estate tax, we here at Basics & Beyond™ highly recommend enrolling in a dedicated income tax seminar for tax professionals. An in-person seminar or affordable online tax webinar is a great way to bring yourself up to speed with all of the detailed changes to the tax code in general, along with those that pertain to decedents and the estate tax in particular.
That said, while it would be impossible to cover the estate tax in depth within the scope of this blog, we’ll outline some of the most important thing about decedents, the estate tax, form 1041, and the changes to the tax code enacted as part of the Tax Cuts and Jobs Act. This will help give you an overview of what you need to know, and from there you’ll be free to sign up for an income tax seminar to gain full mastery over the material as a tax professional.
Below, we’ll discuss:
- What a decedent is according to the IRS
- The difference between income tax and the estate tax
- Form 1041 and the estate tax
- Changes to the estate tax as part of the Tax Cuts and Jobs Act
Ready to find out more? Let’s begin.
What Is a Decedent?
Before going any further in terms of attempting to understand the estate tax, it’s important to take a moment to review the definition of a decedent. In the world of tax and estate planning, tax law, and accounting, the term “decedent” is used to refer to someone who is deceased. So long as this deceased person was a taxpayer, the possessions belonging to them are considered to be part of the decedent’s so-called “estate,” to which the taxpayer is now the “decedent.” Provided that the decedent engaged in some form of estate planning prior to their death, they continue to have a kind of legal decision-making capacity of their estate after their death (following the preparations that they undertook before passing away). It’s important to understand this last point. From a legal and financial angle, someone doesn’t simply disappear upon their death. While the person may no longer be of this world, their financial legacy is still very much present — and it has to be dealt with, one way or another.
This is where the estate tax comes in. Every decedent must file a final tax return for the year that they died. In other words, the fact that you passed away in the middle of a tax year doesn’t exempt you from filing federal income taxes. Far from it, actually. For one thing, the final tax return itself must address standard annual federal tax return concerns: the decedent’s income from employment, investments, and so on must be included, and taxes must be paid according to standard rules and regulations. In addition, though, an estate tax return may need to be filed to handle any taxes assessed on the estate associated with the decedent. We’ll discuss this in greater detail below. It’s worth keeping in mind that a decedent’s death certificate must be attached to their final tax return as proof that they’re passed away. The final tax return is generally filed by either the decedent’s personal representative or executor, as outlined in their will.
Income Tax vs. Estate Tax
As mentioned above, a final income tax return must be filed for the tax year in which a decedent passed away. This final income tax return is similar to a standard annual federal income tax return and will include income from various sources such as employment and investments. In addition, though, a decedent’s executor or personal representative may need to file an estate tax return as well. However, estate tax returns may or may not involve paying the so-called “estate tax.” We’ll discuss the threshold and other rules associated with the estate tax below. For now, it’s important to understand that while all decedents must file a final tax return, only those with a very high net worth will be required to pay estate tax on the value of their estate. In other words, a decedent can be expected to file a personal income tax return as they normally would, along with a special estate tax return for their estate. However, they may only pay standard income tax on this estate tax return, and will only need to pay the so-called “estate tax” if they have a very high net worth.
Generally speaking, an estate tax return (IRS form 1041) must be filed for any estate that generated more than $600 in gross income during the year of the decedent’s death. These forms of income might include rent payments from real estate held by the decedent following their death, a portion of a salary paid out to the decedent after they passed away, or interest on investments and other bank accounts. Keep in mind that the mere existence of personal assets doesn’t always necessitate the filing of an estate tax return. This is where estate tax planning comes in. If an individual immediately transfers the possession of certain assets to other parties following their death, it might not be necessary to file a separate estate tax return, since those assets won’t be generating value in the name of the decedent during the remainder of the year. One example of this sort of estate planning might be the immediate transfer of a jointly owned home or bank account to a decedent’s partner upon their death. Since the home or bank account in question immediately become the sole property of the decedent’s partner following their passing, there’s no need to include these items as income sources on a separate estate tax return.
Form 1041 and the Estate Tax
We often see IRS form 1041, the U.S. income Tax Return for Estates and Trusts form, referred to as a “fiduciary” return form. This is because the form is filed by a fiduciary (or executor) of the decedent, rather than the decedent themselves. When filing form 1041, you won’t use the decedent’s social security number as the tax ID number for the form. Instead, you’ll need to apply for a tax ID number for the estate. This can be done via the IRS website, where you’ll be able to receive an employer identification number (EIN) for the estate. This can be confusing, as we generally think of employer identification numbers as only applying to S-corps, C-corps, and other business entities. However, it’s important to obtain a tax ID number before filing form 1041. The tax year for the estate starts on the day of the decedent’s death. As the executor of the decedent’s estate, you’ll have up to 12 months from the day of their passing to file an estate tax return.
A number of deductions can be included in an estate tax return. First and foremost, every estate gets a $600 tax exemption. This is why there’s often no need to file an estate tax return when a decedent’s estate generated less than $600 in income. In addition to this deduction, you can also deduct:
- Fees paid to attorneys, tax preparers, accountants, and other professionals associated with the estate’s financial preparations
- Fees associated with the executor, assuming the executor was paid a fee to provide specific services to the estate
- Any distributions paid out to the estate’s beneficiaries
- Certain miscellaneous expenses, so long as they exceed 2% of the total adjusted gross income of the estate
Note that funeral and medical expenses cannot be deducted on form 1041. However, it may be possible to deduct these expenses as part of the decedent’s final income tax return. Remember, any amounts distributed to beneficiaries are taxable on those beneficiaries’ income tax returns. Be sure that you provide each beneficiary with a schedule K-1 form as part of filing form 1041, so that those beneficiaries can report that income on their annual federal income tax returns. Also, keep in mind that it’s the executor’s responsibility to actually pay any income taxes that might be due by the estate. These taxes should be paid using the estate’s assets.
Changes to the Estate Tax Following the Tax Cuts and Jobs Act
The recent Tax Cuts and Jobs Act legislation is the most sweeping and wide-reaching tax reform we’ve seen in decades. Clocking in at more than 1,100 pages, the new tax reform bill includes changes to literally hundreds of aspects of the tax code. Amongst these changes are important alterations to the estate tax. As mentioned above, every qualifying estate must file a so-called estate tax return in addition to a decedent’s personal federal income tax return. However, only estates of a very high net worth must pay actual “estate taxes” at the special estate tax rates. If these net worth thresholds aren’t met, any taxes owed by the estate are calculated at standard income tax levels. Until the recent tax reform legislation, a decedent’s estate was exempt from the estate tax so long as their estate totaled less than $5.49 million. A spouse could transfer up to $10.98 million, or twice this amount. Beyond these amounts, any transfers from a decedent’s estate would be taxed at a 40% rate, the estate tax rate, rather than at standard income tax levels. Following the new Tax Cuts and Jobs Act tax reform legislation, the exemption amount has increased significantly. As of 2018, the exemption rates are more than doubled: an individual decedent’s estate is exempt for up to $11.2 million in assets, with a $22.4 million exemption for spouses. These new exemptions are in effect until 2025, at which point they’re subject to congressional reassessment. Beyond these amounts, the 40% estate tax still applies to any transfers pertaining to the estate.
Income Tax Seminars for Tax Professionals
In this article, we’ve touched on some of the most important aspects of the estate tax. However, we highly recommend enrolling in a specialized income tax seminar for tax professionals. Basics & Beyond is a NASBA-approved providers of high quality, engaging, and affordable tax webinars. Learn everything you need to know about the new tax reform legislation from the comfort of your home or office! Click here to sign up for an income tax seminar today.