The Essential Executor's Handbook: A Quick and Handy Resource for Dealing With Wills, Trusts, Benefits, and Probate (2016)

Chapter 5

The Accountant: Taxes Aren’t Just for the Living

Decedents’ tax liabilities do not end with their deaths. Not only do they have to cough up income taxes for their last year of life, but, now that they’re dead, new income taxes spring up. And then there is something known generically as transfer taxes. In this chapter, you are going to learn the basic rules governing these death taxes. Don’t worry: there is some serious math involved but you are going to let your accountant handle that.

Fiduciary Income Taxes

Remember the Probate Estate you learned about in Chapter 1? In tax law, that’s a person. As a person, it is required to pay income taxes. Income tax on what, you ask? Income tax on things like interest from bank accounts, dividends from stocks and mutual funds, rents from real estate, and capital gain from the sale of those things. In short, all of the probate assets that were generating income for the decedents before they died are now owned by the Probate Estate. As a result, the Probate Estate has income and the IRS would like a piece of it.

Remember the Trust Estate you learned about in Chapter 1? That, too, is now a taxable person. Normally, living trusts are not taxable persons so long as they can be revoked. But when the only person who could have revoked it has gone toes up, its status naturally changes. Just as with the Probate Estate, income generated by trust assets are still taxable.

Now the cool thing about Probate Estates and Irrevocable Trusts is that they both get a deduction for any income they pass on to beneficiaries (known as Distributable Net Income or DNI). As a result, the income tax burden actually shifts to the beneficiaries. And that’s a good thing since, in most cases, “natural persons” (i.e., taxpayers with 46 chromosomes) pay income tax at a much lower rate. Your accountant will use a computer program to calculate the tax the Probate Estate or Trust Estate would have to pay if income is not distributed and compare it to the likely tax the beneficiaries would have to pay if the income is distributed to them. With your consent, the accountant will then go with the scenario that generates the lowest tax.

Although the accountant prepares the fiduciary income tax returns each year, it is ultimately the responsibility of the executor (Probate Estate) and the trustee (Trust Estate) to file those returns and pay the tax. It’s your butt that will be in the legal sling if you don’t. And since failure to file returns and pay taxes results in hefty penalties, the beneficiaries will be looking to you to reimburse the estates for the lost cash. You are also responsible for the accuracy of those returns. Accordingly, it is really, really, really important that you hire an accountant who is not just familiar with fiduciary tax returns but one who does them all the time. So if you ask an accountant, “Do you know about DNI?” and the answer is, “Were you arrested for drunk driving?,” move on to the next candidate.

Transfer Taxes

The Federal Estate Tax

Tax law is a funny thing. You can spend your entire lifetime creating wealth despite having to share it with the U.S. Treasury each year and, still, you can owe more tax because you managed to die with too much left over. Sound incredibly unfair? It is. But since tax laws are written by Congressmen and Senators, and since these ladies and gentleman depend on your votes to keep them in gravy, it behooves them to limit the number of voters they subject to an unfair tax. So, although there is a Federal Estate Tax, it only applies to natural persons whose estates total more than $5,430,000. In other words, they chose to offend a really small voting bloc. It’s sort of the same reason burglars prefer to hit homes with the most silver instead of every home on the block: biggest gain for the lowest risk.

In keeping with this notion of revenue without repercussion, the number of decedents subject to the tax is reduced still further by eliminating surviving spouses from the group of taxpayers. In other words, if Bill Gates dies tomorrow and leaves everything to his wife, there will be no estate tax. This is known as the Unlimited Marital Deduction. Of course this merely delays—and usually increases—the tax owed when the wife dies but, politically, that is still better than imposing the tax on a spouse.

The Federal Estate Tax can also be eliminated by distributing all of the assets to charity. But whether you can eliminate the tax depends entirely on how the will and trust are written. If the decedent was rich but single and not disposed to making charitable bequests, the only deductions you will be allowed to take are for costs of administration (i.e., all those professionals you will be hiring).

If after taking deductions for gifts to spouse, gift to charities, and costs of administration, your estates still total more than $5,450,000, the tax rate is 40% of the excess. So, for example, if the taxable estate (i.e., the total of your estates less deductions) is $6,450,000, the tax will be $400,000.

Beyond these basic concepts, the Federal Estate Tax, like the Fiduciary Income Tax, is blindingly complex. So, once again, you will leave the preparation of the Federal Estate Tax return to the professional. In some cases, the return is prepared by the accountant. In some cases, the return is prepared by the lawyer. In most cases, however, the two work together to blunt the tax as much as possible.

State Estate Taxes

Just a head’s up: Some states also impose an estate tax. Most merely copy the Federal Estate Tax but impose a lower tax rate. And then there are some that are truly unique. Nevertheless, all have one thing in common: They are imposed on the total of the estates. Inheritance taxes work on an entirely different principal.

State Inheritance Taxes

The good news is that there is no federal inheritance tax. The bad news is that there are inheritance taxes at all. I say that because of the rationale behind them. Unlike an estate tax, which punishes the decedent for having been too successful, an inheritance tax punishes the estates’ beneficiaries for being too distant a relative or not a relative at all.

For example, let’s say you are informed that your rich uncle has just died and left you a million dollars. You are not all that surprised. You were close to your uncle. You visited him regularly to check up on him. You made sure that his bills were paid, his house was clean, and that he was taking all of his medication. You did this mainly because you loved him but also because you knew his son did nothing for him. The irony is that, if your uncle left a million dollars to his son as well, the inheritance tax you pay will be significantly higher than the tax paid by the son. That is because the inheritance tax rates go up the more distantly you are related to the decedent.

It is important to note that laws vary from one state to the next. So the tax disparity between a son and a nephew will be greater or less depending on where the decedent had resided. Some states, like Virginia, don’t have an inheritance tax at all. In fact, Virginia has neither an estate tax nor an inheritance tax.

These state transfer taxes (i.e., the state estate tax and the state inheritance tax) all have their own tax return forms. Your accountant will know which form to prepare.

What Your Accountant Needs From You

Fiduciary Income Tax Returns

Yeah, it’s great that we have accountants to crunch the numbers for us and wade through all the tax rules and regulations. But you have to supply the raw materials.

So, for example, let’s say that your accountant, Bob, is going to prepare this year’s fiduciary income tax returns. Bob is depending on you to provide all of those income reporting forms that banks and brokers have been sending to you since the beginning of the year. They are easily recognized by the bold statement on the envelope proclaiming, “IMPORTANT TAX DOCUMENT. DO NOT DESTROY.” And they almost always bear the number “1099.”

Once Bob knows what kind of cash the Probate Estate and the Trust Estate have been cranking out, he needs to know about all of the expenses you paid last year and what, if any, distributions you made to beneficiaries. Bob will determine which expenses are deductible and how much income is taxable to the beneficiaries.

So your job here is clear: Keep good records. If you’re the kind of person who never balances your checkbook and doesn’t get the joke, “How can I be overdrawn? I still have checks,” you should hire a bookkeeper. Seriously, while there are many people you can afford to tick off, the IRS agent is not one of them. What’s more, if you don’t give the accountant the needed information and do it in a timely fashion, you just may find yourself without an accountant.

Finally, keep in mind that the accountant may be preparing as many as four annual income tax returns: the federal fiduciary income tax return for the Probate Estate, the state fiduciary income tax return for the Probate Estate, the federal fiduciary income tax return for the Trust Estate, and the state fiduciary income tax return for the Trust Estate. There may also be income tax returns for Ancillary Probate Estates (e.g., rents from real estate in other states). Your job is to make sure that your accountant has prepared all of these returns and, if not, explain why not. Rarely does a good accountant drop the ball but, remember, it’s your keister on the line. Be vigilant.

Federal and State Transfer Tax Returns

Whether it’s an estate tax or an inheritance tax, the accountant—and often the lawyer—requires the date of death values for all of the assets in all of the four estates. Regardless of the type of estate or the type of transfer tax, those valuations are based on the same federal regulations. Here is how they work:

Real Estate—Appraised value. You must hire an appraiser to give you the property’s true value. You cannot rely on the county tax assessment. Assessments can be overvalued because the county simply needs more revenue, or they can be undervalued because they have not been updated for years (sometimes, decades).

Cash—Balance at day’s end. It is a small matter to ask the bank for the exact balance of the decedent’s cash accounts on the date of death. Keep in mind, however, that a bank may only release that information to an executor if the account is a Probate Estate asset, to a trustee if the account was a Trust Estate asset, or to a joint owner or beneficiary if the account was a Contract Estate asset.

Securities—Average of high and low bids on the date of death. It’s OK if you don’t know what a bid is. The broker knows. The broker also has software that quickly and effortlessly computes these figures for you faster than you can say, “Why did I take this job?” The same confidentiality rules apply, however. The broker may not divulge this information to you unless you are the executor, trustee, joint-owner, or beneficiary. (If the decedent did not use a broker, you will have to request this information from each company in which the decedent owned stock.)

Life Insurance—Face amount. The face amount is the insurance amount. So, for example, if you take out a $10,000 life insurance policy, $10,000 is the face amount. It is important to distinguish that figure from the proceeds actually paid out. If there is a delay between the decedent’s date of death and the payout date (there always is), the payout will include interest the insurance company pays for the time it was holding the face amount for you. (Your accountant will report the interest portion on the appropriate fiduciary income tax return.) Usually, only the beneficiary of the policy can get this information.

Retirement Accounts—Balance at day’s end. I’m talking about things like 401(k)s and IRAs. I am not referring to pensions. (Pensions are somewhat antiquated arrangements, whereby an employer continues to pay a retired employee for so long as the retiree shall live. Unlike retirement accounts, pensions die with the retiree.) Usually, only the beneficiary of the retirement account can get this information.

Tangible Personal Property (aka the Knick-Knack Estate)—Valuation depends on whether or not the asset was ever appraised or whether it was insured for a certain value. Otherwise, its value is presumed to be whatever you got when you sold it. If you don’t sell it, you can usually ignore it as having little or no value. Don’t believe me? Go to an estate auction sometime and see solid silver tea services sell for $20. And that’s it. Provide the accountant with those figures and let the calculations commence.

Summing Up

In addition to the decedent’s final income tax return, there are five kinds of taxes for which an executor is responsible: federal fiduciary income tax, state fiduciary income tax, federal estate tax, state estate tax, and state inheritance tax. Your accountant will prepare most or all of these returns for you. However, your accountant is dependent on you to provide the needed information in an accurate and timely manner.

Things to Do

1.   Interview and select your accountant.

2.   Have your accountant obtain Employer Identification Numbers for the Probate Estate and the Trust Estate.

3.   Forward all of the decedent’s tax information forms to your accountant as soon as you receive them (e.g., W-2, 1099).

4.   Prepare a list of the decedent’s assets and debts, and provide a copy to both your attorney and your accountant.

5.   Promptly provide anything else your accountant requires.