I’m sure you’ve heard the adage about nothing in life being certain except death and taxes. However, if you are settling the affairs of a loved one who has died, you may not be so certain about dealing with your responsibilities regarding taxes.
Many people have heard about estate or inheritance taxes, but for the vast majority of people in Indiana, inheritance tax is not an issue under current law. Indiana presently does not have an inheritance tax, and for 99.9% of the 2.7 million people who died in the United States in 2018, there will be no federal estate tax charged to their estate. (In 2018, the estate tax exemption was raised to $11.18 million for an individual.)
However, income taxes must still be addressed when someone dies. First, the decedent’s final personal income tax return must be filed. Even if the individual dies prior to filing taxes for the prior year, the IRS requires a return to be filed for the year of death if he or she had income during that year. For example, Jerry died on February 2, 2019, before having filed his 2018 tax return. Jerry’s daughter Marsha is the Personal Representative of Jerry’s estate. She must ensure that Jerry’s 2018 personal income tax return is filed, and she must also file a tax return to report any income Jerry received in 2019. An individual’s final income tax return is filed using the same forms (typically a Form 1040) that are used for a living person. If the deceased person is married and his or her spouse files a joint return, the spouse can still typically file a joint return in the year of the individual’s death.
Additionally, if an estate is opened for the decedent, the estate may have to pay income taxes as well. For example, if Jerry owned stock when he died, and his estate receives dividends or earns capital gains upon the sale of those investments, the dividends and capital gains are income to his estate. The net income of Jerry’s estate will be divided among Jerry’s beneficiaries when Marsha distributes the estate’s assets. Marsha, as Personal Representative, will file an estate income tax return to report the income to the estate, but she will also likely issue a “Schedule K-1” for each beneficiary. The K-1 requires each beneficiary to pay the income tax on his or her share of the estate’s income. The beneficiary reports the income from the K-1 on his or her personal return. While this might sound like a tough break for the beneficiaries, it is typically beneficial to them. All other things being equal, an individual will pay much less in income tax than an estate will on the same amount of income. For example, if Jerry’s estate had $15,000 in taxable income, the estate would have to pay roughly $3,900 in income taxes if it does not pass that income on to the beneficiaries. (The marginal tax rate for income over $12,750 is 37% for estates and trusts.) However, if the estate’s income is distributed equally among Jerry’s three daughters, Marsha, Mindy, and Melissa, each daughter will receive a K-1 showing income to her of $5,000, which she will report on her personal tax return. If Marsha, Mindy, and Melissa each has income that puts her in the 22% income tax bracket, the daughters together would pay $3,300 in income taxes (each would pay $1,100), for a tax savings to the estate of $600.
Remember that the taxes Jerry’s daughters are paying are only on the income earned by the estate. If each daughter receives an inheritance from Jerry of $100,000, but only $5,000 of that share is income to the estate, each daughter will only pay income tax on the $5,000. She will not have to pay income tax on the rest of her inheritance.
Fortunately, accountants have much more certainty about the tax aspects of death than the rest of us do. We always recommend that our clients consult an accountant who is experienced in dealing with estate income tax issues to ensure that all tax issues are resolved before the estate is closed.