It seems that in most marriages, one spouse gets the dirty duty of acting as the family accountant. If your late spouse was in charge of tax returns, you may not have much experience in such matters. They may, in fact, even scare the hell out of you. Even as you read now, you may have just remembered that your dog needs more water in his dish, or that you need to check your supply of furnace filters. Though you may be tempted, try not to “check out.” It is not expected that you will learn to prepare tax returns by reading this chapter, only that you understand what returns are due and their function. Certainly, tax returns cannot be ignored.

Unless you have a strong accounting background, you will need the assistance of a Certified Public Accountant (“CPA”). You are best advised to contact a CPA as soon as possible to begin to gather the information you will need to timely file the tax returns described in this chapter.

Even if you intend to hire a CPA, reading this chapter will make you a better teammate in a “taxing” undertaking. If you already use the services of a CPA, it is best to continue with someone who knows you and understands your situation. Naturally, you continue to be responsible to file a personal income tax return (Form 1040), but the rules change somewhat as a result of your spouse’s death.

If you are the personal representative of your late spouse’s estate, or the trustee of his trust, you must also file income tax returns for the estate or trust. If your late spouse’s taxable estate exceeds the Applicable Exclusion Amount ($1,000,000 in 2002), you may be required to file a Federal estate tax return.

If you or your late spouse made taxable gifts, you may be required to file gift tax returns (Form 709). The following returns are discussed in great detail in this chapter:

FORM 1040

Despite your spouse’s death, for a limited time you may still take your late spouse’s exemptions and file a joint tax return. You are eligible to elect “married filing jointly” status in the year of your spouse’s death, which in most cases produces the best tax result.

However, you may choose to file separately (“married filing separately”) if your late spouse was in trouble with the IRS, or you believe he may have committed tax fraud in the year of his death. If you were to file jointly, you would expose yourself to his tax debts or even his fraud.

In some cases, married filing separately may even generate more Schedule A deductions. That would be the case if there were large medical expenses incurred in the year of death. Your accountant should prepare Form 1040 using each status to determine which filing status nets you the best result. If you file jointly, you must sign both personally and as your spouse’s personal representative.

You may file jointly for two tax years following the year of your spouse’s death as a “qualifying widow or widower with dependent child,” if all of the following conditions are met:

1. You were entitled to file a joint return in the year of death, whether or not you actually did;
2. You have not remarried;
3. You have a child, stepchild or foster child that qualifies as your dependent; and
4. You provide more than one-half the cost of maintaining your home, which is the principal residence of the child. If the above conditions are not met, you must file as a “single” taxpayer, and will likely pay a significantly higher tax.

Example: Mr. Brown’s wife died in 2001. As of 2002, Mr. Brown had not remarried and continued throughout 2002 to maintain a household for himself and their child. In 2001 Mr. Brown was entitled to file as married filing jointly with his deceased wife. For year 2002 he again qualifies for the more advantageous joint tax tables. He will be eligible to file a joint return for 2003 if he continues to meet the requirements described above.

When filing Form 1040 in the year of death (or short Form 1040A for taxpayers with minimal deductions and taxable income of less than $50,000), several disclosures must be made. In the name and address section on the top of Form 1040, you must indicate that your spouse is “deceased” and enter the date of death.

Additionally, in the signature block on page 2 you must also indicate, “deceased.” Your signature should be followed by the words “filing as surviving spouse.”

The following is an example of the relevant portions of pages one and two of Form 1040:

Unless you moved in the year of your spouse’s death, Form 1040 is filed with the same IRS center that you filed with the previous year. If you are not your spouse’s personal representative, Form 1040 is filed with the IRS center determined by the residence of the personal representative.

If you did not remarry, your joint return for the year of death will include your late spouse’s income and deductions up to the date of his death. It will also include your income and deductions for the entire year. Income from your spouse’s employment, retirement plans, or other income paid to you in the year of death is included on the joint return. Income from your spouse’s employment, retirement plans, or investments paid to your late spouse’s estate or trust must be reflected on Form 1041 discussed below.

1040 ESTIMATED TAX PAYMENTS

The passing of your spouse may affect both your level of income and tax withholding. If your spouse was working, income tax was withheld from his or her paycheck. Naturally, once the paychecks stop so does the withholding.

After your spouse’s death, you may begin to live off of other sources of income such as retirement distributions, or proceeds from the sale of investment assets. If tax is not withheld from these new sources of income, you could be subject to withholding penalties.

Federal and state law requires that either 100% of the prior year’s tax liability (or approximately 110% percent for individuals with more that $150,000 of adjusted gross income) or at least 90% of current annual tax liability either be withheld from payroll or paid to the government in what are called “quarterly estimated payments.”

Failure to properly withhold can result in substantial penalties. Unfortunately, the death of your spouse does not exempt you from the withholding rules. Estimated taxes are paid four (4) times during the year: April 15th, June 15th, September 15th, and the following January 15th.

Considering the substantial income fluctuations that naturally occur in the year of death, it is likely that estimated payments will be necessary.

To ensure proper income tax reporting, you should promptly notify the appropriate financial institutions of your spouse’s death. Your spouse’s name should be removed from your joint accounts, with your social security number added in place of his on each account.

Trust and probate assets should be changed to reflect the new tax identification numbers issued by the IRS from information you submit on Form SS4. Financial institutions are required to file information returns (Form 1099) with the IRS.

The IRS uses this information to determine whether taxpayers have accurately reported their dividend, interest and other income. Failure to promptly change tax identification numbers, especially on estate or trust assets, will result in misreporting of 1099 income.

Post-death income would be improperly reported to the IRS as income of your late spouse rather than income of the estate or trust. If, in fact, you receive 1009s that do not reflect the responsible taxpayer, you must first report the income on the return of the taxpayer listed on the 1099.

You then deduct the erroneous income from the return in what is called a “nominee distribution,” identifying the correct taxpayer. The responsible taxpayer must then report the income.

The following is an example of page one of Form SS-4:

MEDICAL EXPENSES

Substantial un-reimbursed medical expenses are often incurred in the year of death. Such expenses are generally not paid until after death. The general rule is that medical expenses are deductible when paid.

However, an election can be made that will allow you to deduct medical expenses in the year incurred (rather than when later paid) as long as they are paid within one year of the date of death.

The election is made on Form 1040 (see example below). Alternatively, you may elect to deduct medical expenses on the estate tax return (Form 706) in lieu of an income tax deduction. However, since there is rarely any estate tax due at the death of the first spouse, it will almost always be preferable to elect to take medical expenses as an income tax deduction.

Medical expenses may not be deducted from trust or estate income (Form 1041).

INCOME TAX DEDUCTION FOR ESTATE TAX PAID

Income in respect of a decedent, or “IRD,” is income earned during the life of the decedent that is paid out after death. Typical items of IRD include pension, IRA, and 401k distributions, bond interest, annuity payments, as well as the decedent’s last paycheck.

Since IRD is subject to both income and estate tax, it is subject to double tax. Fortunately, recipients of IRD are entitled to an income tax deduction that somewhat offsets the effect of the double tax.

The amount of the deduction is determined by computing the Federal estate tax with the IRD included and then re-computing the tax with the IRD excluded. The income tax deduction is the difference between the two results.

Estates and irrevocable trusts (including revocable trusts that become irrevocable upon the death of the grantor) must file and report income tax on an annual basis. The first taxable year of a probate estate or a revocable trust begins the day of the decedent’s death. As noted above, it is important that all assets owned by the estate or trust carry the proper tax identification number. Tax preparation will be a lot easier for you and your accountant if 1099s properly match income with the responsible taxpayer.

Form 1041 must be filed annually for so long as the estate or trust has income that exceeds $600. Since probate estates can usually be wrapped up in a calendar year or two, only one or two 1041s will be required. Trusts, depending on their terms, may last for many years. For example, a trust for the benefit of the surviving spouse for the balance of his or her lifetime, or for children until their “35th birthday,” may continue for decades after the decedent’s death.

The following is an example of page one of Form 1041:

The decedent’s personal representative is responsible for filing Form 1041 on behalf of the estate, and the trustee on behalf of the trust. As noted in Chapter Seven, personal representatives and trustees are “fiduciaries,” and as such, must prepare and sign all returns. If your late spouse had several trusts, each must be assigned its own a tax identification number and must file Form 1041 annually.

For example, your late spouse may have had an Irrevocable Life Insurance Trust (See Chapter Nine, “Irrevocable Trusts”), as well as sub-trusts contained within his or her revocable trust known as family and marital Trusts (See Chapter Seven).

Probate estates may elect a non-calendar fiscal year. The filing of the first return constitutes the irrevocable election of a tax year. The first taxable year of an estate begins on the date of the decedent’s death and ends on the last day of any month that is not more than twelve months from the date of death.

For example, if your spouse died June 15, 2001, you may elect a fiscal year ending as late as May 31, 2002. A non-calendar year fiscal year allows you more time to get organized after the death of a spouse, as well as limited income tax deferral. In the example above, year 2001 income would be reported on the May 31, 2002 tax return, allowing you to report 2001 trust or estate income on your 2002 personal income tax return.

Except in the limited circumstance of trusts that elect to be taxed as estates, trusts must report income on a calendar year basis. If , as personal representative and trustee, you so elect, the trust will be treated and taxed as part of the estate and not as a separate trust. The election allows the filing of a single Form 1041 and the election of a single non-calendar fiscal year.

Combined reporting may continue for up to six months after the IRS issues its final determination of estate tax liability. If no estate tax return (Form 706) is required to be filed, combined income tax reporting may continue for up to two years after the date of your late spouse’s death. The election is made on the first Form 1041 filed for the estate and is irrevocable.

The election is most useful for estates and trusts that by their terms will be fully disbursed within a year or two following death, and is of little use for trusts that will continue for many years after the death of your spouse.

For Example: Harry is married to Wendy. He has a revocable trust and dies on June 22, 2001. Wendy discovers a sizable bank account in Harry’s name alone (she wonders why he didn’t tell her about it!), and must therefore open a probate estate. Both the trust and estate earn enough income to require the filing of income tax returns. Wendy receives distributions from the trust between June 23 and December 31, 2001. Wendy is required to pay income tax on those distributions reporting them on Form 1040. If the trust uses the calendar year as its tax year, which is the usual requirement, Wendy will have to report the distributions as part of her 2001 income. However, if the trust elects to be taxed as an estate, it does not have to use the calendar year and can chose any tax year (as long as the first year is not longer than 12 months). Let’s say that Mary as Harry’s personal representative chooses May 31, 2002 as the estate’s fiscal year. If Mary also elects to have the trust taxed as an estate, the trust distributions Wendy received in 2001 will not be counted as income to her in 2001. Instead, trust income will be added to estate income and reported on the estate’s first tax return for the year ended May 31, 2002. Accordingly, Mary will report first year trust and estate income as part of her 2002 income, allowing her to defer trust income an entire year. In addition, Mary only need file one Form 1041 covering both the estate and trust.

The due date for filing Form 1041 is the 15th day of 4th month following close of the tax year (April 15th for calendar fiscal years). Trusts are granted an automatic extension of time to file (not an extension to pay) for 90 days by filing form 8736. An additional 90 days extension (beyond the first 90 day extension) may be granted by filing Form 8800, if “reasonable cause’ can be established.

By contrast, estates are not automatically granted an extension of time to file Form 1041. An estate must show “reasonable cause” as to why the return cannot be filed on time. The maximum extension allowed is 6 months from the original due date. As with all extensions, an extension of time to file is not an extension of time to pay the tax. Accordingly, a tax payment (“tentative tax”) must be made on or before the original due date. If the tentative tax paid with the request for an extension is insufficient, penalties and interest on the shortfall may be imposed. Form 2758 is used to apply for an extension to file Form 1041.

Trust and estate income is taxed at an extremely high marginal rate. Income not distributed during the year is taxed to the trust or estate. Distributions to trust beneficiaries during the year or within 65 days after the end of the year generate a distribution deduction to the trust or estate.

Such distributions are included in the income of the recipient beneficiary at his or her marginal tax rate. The effect of the distribution deduction is to shift income tax liability from the trust or estate to the recipient beneficiaries. Since trusts and estates are in a much higher tax bracket, distribution of income to beneficiaries is desirable.

The trustee or the personal representative must be ever vigilant against accumulating income in the estate or trust and thereby paying unnecessary income tax.

The following chart compares the tax rate of married couples filing jointly to that of trusts and estates:

As you can see, the tax rate is substantially higher for 1041 income. An estate or trust reaches the maximum tax rate of 39.6% with only $8900 of taxable income, while a married couple filing jointly doesn’t reach the maximum tax rate until they have $297,350 of taxable income.

As noted, trusts and estates are permitted a distribution deduction for distributions to beneficiaries during the tax year or within 65 days of the end of the year. The 65-day rule allows the trustee or personal representatives time to assess trust or estate income tax liability for the year and to make distributions to shift income tax liability to the beneficiaries.

For calendar year trusts and estates, the 65-day period coincides with the deadline for issuance of 1099s. Taxpayers, including trusts and estate, must receive forms 1099 by January 31st. The 65-day rule allows trustees and personal representatives time between January 31 (when they receive trust and estate 1099s) and March 5th (the deadline for making distributions) to assess their tax liability and to make trust or estate distributions that will achieve the optimal application of the marginal tax rates between the entity and the beneficiary.

Distributions within the 65-day period relate back to the previous tax year. The trust or estate is allowed to deduct distributions in the 65 day period as if made during the previous tax year. Likewise, beneficiaries must report the distribution as if received on the last day of the trust or estate’s immediately preceding tax year.

Distributions generate a deduction only to the extent of the trust or estate’s distributable net income (“DNI”). Basically, DNI is the trust or estate’s taxable income for the year. Distributions in excess of DNI are not deductible to the trust or estate and are not taxable to beneficiaries.

Distributions are first considered distributions of DNI and qualify for a distribution deduction. Specific bequests such as “$10,000 to my cousin Vinny” are not considered taxable distributions. The tax Code recognizes that the decedent probably did not want cousin Vinny to pay income tax on the remembrance left to him by the decedent.

Form K-1 is an attachment to Form 1041. A separate K-1 is prepared for each beneficiary to reflect his or her share of trust or estate income and loss. Beneficiaries must wait to prepare their 1040 until they have received their K-1. The K-1 will not only indicate the amount of income and loss to be included on their personal return, but also the character (i.e., capital versus ordinary, long term versus short term).

The following is an example of page one of Form K-1:

1041 ESTIMATED TAX PAYMENTS

If an estate or trust owes more than $1,000 in tax for the current year, it must make estimated tax payments. The rules of estate and trust estimated payments are the same as those for individuals; that is, either 100% of the prior year’s tax (110% percent for trusts and estates with adjustable gross income of more than $150,000) or 90% of the current year tax due.

Like individuals, estimated tax payments for trusts and estates must be made in four quarterly installments. Unlike individuals, estates and revocable trusts that become irrevocable at death, are not required to make estimated tax payments until the first tax year ending 2 years after the decedent’s death.

For example: If your spouse dies March 15, 2000 and you adopt a January 31, 2001 fiscal year, the first tax year that estimated tax payments are required is the year ended January 31, 2003 (i.e. the first tax year ending two years after March 15, 2000). If the estate closes prior to February 1, 2002, no estimated tax payment is ever due.

COSTS OF ADMINISTRATION

Estates and trusts may deduct expenses incurred for the collection of assets, the payment of debts, and the distribution of the property to beneficiaries and heirs. Administration expenses include executor’s commissions, real estate commissions, attorney’s fees, court costs, appraiser’s fees, interest, accounting fees, and brokerage fees.

Administration expenses are deductible either against income on Form 1041 or as an expense of the estate on Form 706. Since it is unlikely that estate tax is due at your spouse’s death, you should deduct administrative expenses on Form 1041.

You should meet with your CPA no later than two or three months after your spouse’s death. If you don’t have a CPA, or your CPA is not qualified to assist you in the matters discussed in this chapter, see “Choosing a CPA” at the end of this chapter. The initial meeting with your CPA is needed to strategize as to the most appropriate fiscal year for your late spouse’s estate and trust(s).

Once you have agreed on a tax year, you should agree to meet again sometime within the 65-day period discussed above. At the second meeting, you and your CPA can review income and expenses of the estate and trust(s) and determine what distributions should be made from the estate or trusts to achieve the optimal income tax result.

To better track income and expenses, you should maintain a single checking account for the estate and each trust (using the appropriate tax identification numbers). All disbursements should be made from these checking accounts. Each check register will provide a clear record of administrative expenses and evidence of distributions made to beneficiaries.

With these things in mind, and having already met with your CPA at least twice after your spouse’s death, you should bring the following information to your CPA at tax time:

1. Your last three federal and state personal income tax returns;
2. All current year 1099s (1099-DIV, 1099-INT, 1099-MISC, 1099-R);
3. All current K-ls and W2s;
4. Evidence of deductible expenses;
5. Evidence of distributions to beneficiaries;
6. The tax identification numbers of the estate and any trusts (bring copies of filed SS4s);
7. The name, address, and social security number of all estate and trust heirs and beneficiaries.

FORM 706

For the most part, the unlimited marital deduction eliminates the possibility of any estate tax at the death of the first spouse. Only where the surviving spouse is a non-U.S. citizen, or where the surviving spouse is not the beneficiary of a substantial portion of the decedent’s estate, will an estate tax be due at the death of a married individual. You should immediately consult an estate tax attorney if you are not a U.S. citizen.

Even though it is unlikely that estate tax is due as a result of your spouse’s death, Form 706 must nonetheless be filed if your late spouse’s gross estate, plus his or her lifetime taxable gifts, exceeds the “Applicable Exclusion Amount”. The Applicable Credit Amount for 2002 is $1,000,000 and is scheduled to increase to $3,500,000 by 2009 before the estate tax is scheduled to be repealed in 2010:

*The repeal of the federal estate tax in 2010 will occur only if Congress votes to ratify the repeal at a future date.

Following is an example of Form 706:

Form 706 is extremely difficult to prepare, and should be prepared by an estate tax attorney, or by CPA familiar with estate and gift taxation. Form 706 is due nine months after death. Although nine months may seem like a long time, the detailed information that must be compiled makes Form 706 a challenge to complete in the allotted time. As your late spouse’s personal representative, you must sign form 706.

If you can demonstrate sufficient cause, a six-month extension of time to file may be granted by filing Form 4768. The six-month extension is only an extension of time to file and not an extension to pay. An estimated tax payment, if applicable, must accompany Form 4768.

To coin a phrase, Form 706 is “where the rubber meets the road” in estate planning. Form 706 is where you tell the IRS your late spouse’s life story. In addition to current asset and liability information, a detailed history of all taxable gifts must be disclosed.

Copies of your late spouse’s Will and trust must be submitted along with Form 706. Although no tax may be due, important elections such as the election to treat the marital trust as a QTIP trust, the election to value assets six months after the date of death (Alternate Valuation Date), the election to qualify the family business as a Qualified Family Owned Business Interest (“QFOBI”), among others, must be made on Form 706.

The starting point in completing Form 706 is to determine your late spouse’s gross estate. Basically, the gross estate consists all assets which your late spouse had an interest during life including life insurance, IRAs, 401ks, real estate, cash, stocks, annuities, promissory notes receivable, bonds, jewelry, personal property, as well as interests in closely held businesses, whether held in individual name or in his or her revocable trust (See Chapter Nine, “Planning to Avoid Estate Tax”).

All assets that make up your late spouse’s “gross estate” must be valued as of the date of death (See Chapter Two for the specific information that needs to be gathered). Various deductions, including debts, are deducted from the gross estate to arrive at the “adjustable gross estate.”

Difficult to value assets such as real estate and interests in closely held businesses must be appraised by a licensed appraiser. The single most audited and litigated issue is the value of assets listed on Form 706.

Having a professional appraiser value difficult to value assets will minimize your chances of audit and enhance your piece of mind. Although appraisals are expensive (other than those for residential real estate), potentially running in the thousands of dollars, they greatly increase the chances of having your 706 accepted “as filed.” All appraisals should be in writing and attached to Form 706 when submitted to the IRS.

If the estate declines in value after death, you may elect to report the value as of the date that is six months after death (i.e. the “Alternate Valuation Date”). Assets sold or distributed during the six-month period are valued as of the date of sale or transfer.

You can expect to receive an initial response from the IRS within six months of filing Form 706. At such time, the IRS may simply issue a closing letter accepting the return as filed, or it may request further information, or audit the return. Returns filed at the death of the first spouse have a low audit profile and are typically accepted as filed.

DISCLAIMER

You may elect to “disclaim” property left to you by your late spouse. Assets disclaimed by you pass to those who would have received you late spouse’s assets had you predeceased him or her. At first blush, disclaiming assets may sound insane. However, disclaiming assets may make excellent tax sense if your spouse left everything to you and consequently failed to use his or her unified credit.

By disclaiming assets you can fully use your late spouse’s unified credit, effectively doubling the amount you can leave to children free of estate tax (See Chapter Nine, “Planning to Avoid Estate Tax”).

To be qualified, the disclaimer must be irrevocable, in writing, and made within 9 months of death. You may not accept possession of disclaimed assets (for example, cashing the proceeds of a life insurance policy would make the policy ineligible for disclaimer), and the disclaimed assets must pass to someone other than you.

STATE INHERITANCE TAX

All 50 states have some form of inheritance tax return. Each state has different forms and rules, but all tend to evolve from federal Law. You should obtain a copy of your state’s forms and instructions. Thirty-three states have adopted a form of “pick-up” tax, where the state collects a portion of the federal estate tax that would have been due the federal government if not for the state death tax credit available on the federal return. The remaining states have a separate tax not limited to the federal state tax credit.

Taxable gifts made during life reduce the amount the decedent may leave tax-free at death. Taxable gifts are gifts in excess of the $10,000 gift tax exclusion (See Chapter Nine “Gifting”). Form 709 must be filed for any year a taxable gift is made.

Taxable gifts for which no Form 709 was filed should be documented after death. As personal representative, you must prepare and sign Form 709. Significant tax savings may be available where you and your late spouse made lifetime gifts but failed to Form file 709. You may “split” the gift on Form 709, and essentially double your gift tax exclusion.

Form 709 is due on April 15th following the year in which the gift is made. A six-month extension is permitted. Post mortem gift tax returns must be filed by April 15th of the year following the year of death or the due date of Form 706 whichever is earlier. The minimum penalty for failing to file a 709 is $100, even if no tax is due.

Generally, gift tax returns should be filed on a timely basis in order to start the running of the statute of limitations. The IRS has only three years from the date of filing Form 709 to audit the return. By contrast, there is no limit on the time the IRS can audit gifts where no Form 709 was filed. Carefully documenting gifts limits the IRS’s ability to scrutinize gifts years later, even after the death of the donor.

The following is an example of page one of Form 709: