Many of us hear about the estate tax and, particularly, who needs to pay it.  The current law excludes estates and trusts from paying the estate tax if the value of the assets in the estate or trust is under $5,250,000.  That’s great news!  The estate tax is essentially 40% of the excess over $5,250,000.  The estate tax is a transfer tax on wealth.  While there are many ways to minimize this tax on large estates and trusts, that is not the subject of this blog.

Many people believe that as long as an estate or trust is under $5,250,000 there is no tax obligation.  Let me give you an example.  Mom and dad have passed away, and the value of their entire estate was $500,000.  This included a personal residence, some stocks and mutual funds, and dad’s IRA.  The house, stocks and mutual funds are sold, and the IRA is cashed out, resulting in $500,000 in cash.  The cash is distributed to the two adult children.  The estate was under $5,250,000 so one would think there is no tax effect.  Imagine the surprise of brother and sister when they receive a tax form from the estate saying they each have $75,000 in taxable income that must be reported on their 1040!  What happened?

It is true that there is no estate tax on the estate in the above example.  However, recall that the estate tax is a transfer tax.  The estate is still subject to the estate INCOME tax (this applies to trusts as well).  Any income earned by the above estate, which would take place after the death of the final parent, is subject to income tax.  SOMEBODY has to pay the tax on it!  The parent cannot pay the income tax because it was recognized after their death.  That leaves either the estate or the beneficiaries (in this case, brother and sister).  Now, in the above example, what assets are considered taxable?  There would likely be little to no income recognized on the sale of the personal residence or the stocks and mutual funds provided they were sold close to the date of death (this is because of the step-up basis rules on assets, but that is a subject for another blog).  However, traditional IRA’s are deferred compensation plans.  They are taxable when the cash is withdrawn.  Had mom or dad cashed out the IRA, even a day before their death, they would have had to report the IRA as income on their 1040.  This IRA is still taxable after their death.  The only difference is that once a person dies their ability to report income on their tax return ends.  The IRA must be reported as income by either the estate or the beneficiaries.  Tax law states that the beneficiaries must generally report the income on their personal 1040’s if they received the cash or certain other kinds of property from the estate in the same year the income was recognized and, in some cases, within 65 days of the following year.

But don’t feel too bad for the brother and sister in the above example.  Had the estate paid the income tax on the IRA it would have owed about $57,000 depending on available deductions.  Assuming the children are in the 25% federal tax bracket their combined tax liability on the same amount of money would be $37,500 (this is an over simplification as the 25% is smaller than the $75,000 reported by each beneficial; in other words, this exact calculation is not possible, but is a close approximation based on median taxpayer data).  Estates and trusts have extremely high tax rates and reach the top bracket of 39.6% very quickly, and this tax must be paid using the cash that would have been distributed to the beneficiaries.  The idea of using them as aggressive tax shelters is a holdover from the 90’s and just is not true anymore.  The more income that can be reported by the beneficiaries, generally, the better.  The beneficiaries then use their inheritance to pay the tax.  They must be made aware to hold on to some of the inheritance for any tax liabilities that may arise.

Estates and trusts report their income on Form 1041.  If you receive cash or property from a deceased individual you should contact a CPA or an attorney to determine if you, the estate or the trust has a filing requirement.  If you are the executor of an estate or the trustee of a trust you should definitely do the same!  Please feel free to contact me if you have any questions regarding this blog.

Gregory M. Daniels, CPA
Daniels Group CPA, PLC
Phone: (248) 855-8400
Cell: (248) 635-7564
www.danielsgroupcpa.com

NOTICE TO PERSONS SUBJECT TO UNITED STATES TAXATION: DISCLOSURE UNDER TREASURY CIRCULAR 230:

The United States Federal tax advice, if any, contained in this document and its attachments may not be used or referred to in the promoting, marketing or recommending of any entity, investment plan or arrangement, nor is
such advice intended or written to be used, and may not be used, by a taxpayer for the purpose of avoiding Federal tax penalties.