Beyond The Will

Death and Taxes – The Three Unavoidable Taxes in Estate Administration

January 24, 2024

   

Death and taxes are often jokingly said to be two of the only unavoidable things in life. Unfortunately, taxes are also unavoidable when someone passes away. When administering an estate or trust after someone’s death, three types of taxes come into play – estate taxes, personal income taxes, and fiduciary income taxes. This article will distinguish each of these types of taxes and describe their roles in estate and trust administration.

Estate Taxes

Estate taxes are often called “inheritance taxes” because it is a tax that the beneficiaries of the estate and trust ultimately have to pay before they can inherit any of the decedent’s property. Even though the estate tax is paid from the estate assets, the estate tax payment ultimately reduces the amount each beneficiary will receive. Estate tax returns must be filed nine months after the decedent’s death but can be put on at least one six-month extension (possibly more, depending on the circumstances).

To complicate the issue further, there are two types of estate taxes – federal and state estate taxes. A decedent’s estate will be subject to federal estate taxes if the value of the estate exceeds $13,610,000 (for 2024). This exemption amount increases annually to adjust for inflation. However, in 2026, the federal estate tax exemption is set to drop to $5,000,000, which will have profound estate tax implications for individuals who pass away in 2026 and beyond.

For estates valued over the federal exemption amount, the estate is taxed on only the amount that surpasses the $13,610,000 threshold. The federal estate tax rates range from 18-40% depending on how much is over the limit. Each tier has a base tax amount that is paid before the tax rate is applied. The base tax amounts range from $0 in the first tier to $345,800 for the top tier.

Depending on the state where the decedent resided, their estate may also be subject to state estate taxes. Seventeen states and the District of Columbia impose taxes on estates (or inheritances). The exemption amounts and tax rates vary by state.

In October 2023, Massachusetts raised its exemption amount from $1,000,000 to $2,000,000 for individuals who pass away on or after January 1, 2023. (Read more about the exemption increase here). However, the $2,000,000 “exemption amount” is realistically treated as a filing threshold in Massachusetts. The estate must then pay a tax on the amount in excess of a $99,600 tax credit.

For example, if an estate is valued at $2,500,000, an estate tax return must be filed, and estate taxes will be imposed on $2,400,400 ($2,500,000 less the $99,600 tax credit). The Massachusetts estate tax rates range from 0.8-16% depending on how much the estate value is over the tax credit. No Massachusetts estate tax return must be filed if an estate is valued at under $2,000,000.

Individuals will often have an estate plan that attempts to avoid or minimize estate taxes at their death. Estate taxes are not an issue for estates valued under the federal or the state exemption amounts. For estates over the $13,610,000 federal exemption amount (or the state exemption amount), the lack of a proper estate plan can result in the beneficiaries paying unnecessary estate taxes.

Personal Income Taxes

The decedent’s estate will also need to pay the income taxes on the income the decedent earned in the year before their death. The deadline to file a decedent’s final, personal income taxes is April 15 of the year following their death, and the return is filed under their Social Security number.

For example, if an individual passed away on July 31, 2023, a personal income tax return would need to be filed by April 15, 2024, and taxes would need to be paid for income earned from January 1, 2023, through July 31, 2023.

If the decedent would have received a tax refund, the check would become part of the estate funds and administered to the beneficiaries. Alternatively, if the decedent owed the IRS tax payments from previous years or had failed to file in the years before their death, the estate must pay the income tax bill.

Fiduciary Income Taxes

The third type of tax applicable when administering an estate or trust is fiduciary income tax. When established, an estate (or trust) is a separate legal entity that has its own tax identification number (often referred to as a “TIN” or “EIN”). Since the estate or trust is an independent legal entity, it is also responsible for income taxes on any income earned during the  estate or trust administration.

To continue the above example, if an individual died on July 31, 2023, their estate would be considered a separate legal entity as of July 31, 2023 (the date of death). Therefore, the estate would be responsible for paying income taxes on any income earned by the estate from July 31, 2023, through December 31, 2023, and for any subsequent years the estate is administered.

Yes, you read that correctly – the estate will be responsible for income earned from the date of the decedent’s death through the end of administration. Depending on the complexity of an estate, the administration can be completed as quickly as within a year of the date of death, or it could span for years. Much like a personal income tax return, the fiduciary income tax return must be filed by April 15 of the following year. For example, for estate and trusts that earned income in 2023, the fiduciary income tax return is due April 15, 2024.

The tax rates imposed on an estate or trust depend on the amount of income earned throughout the year. The lowest is 10%, if annual income earned was $3,100 or less, and the highest is 37%, if the annual income earned is $15,201 or more. Typically, unless the decedent owned investment funds or other accounts that earned high amounts of interest, the estate will not earn much income during the administration.

Who is responsible?

After reading the above, you may be asking yourself, “so who pays for these taxes and who is responsible for filing the returns?” All taxes are paid out of the estate funds (typically before distributions are made to any beneficiaries). The Personal Representative of the decedent’s estate is responsible for filing the decedent’s final personal income tax return, the fiduciary income tax return for the estate, and the estate tax return (if needed). If there is a trust, the Trustee would be responsible for filing the annual fiduciary income tax return for the trust.

Typically, the Personal Representative (or Trustee) would engage an estate administration attorney to prepare the estate tax returns (both state and federal, if needed) and a Certified Public Accountant (“CPA”) to prepare the decedent’s final personal income tax return and the fiduciary income tax return. It is best practice to have one CPA prepare the decedent’s final personal income tax return and the fiduciary income tax return, so income earned in the year of the decedent’s death can be allocated correctly between the two different returns.

Tax returns can be one of the most complicated aspects of administering an estate or trust. Personal Representatives and Trustees should consult legal and professional tax advice to assist with the above-mentioned tax returns to ensure each return is filed timely and correctly.

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