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Tax Returns Necessary After Somebody’s Death

A reader writes in, asking:

“A family member appears to be in his final days. I have not seen his will, but I have been told that I am named as executor. I have never been an executor before, so I am doing some research on what my responsibilities will be. Could you perhaps discuss what tax filings will be necessary?”

Firstly, one thing you should know if you choose to accept the role of executor is that you are allowed to hire assistance (e.g., an attorney to guide you through the process and/or a tax professional to prepare the necessary returns).

And as far as basic tax information, IRS Publication 559: Survivors, Executors, and Administrators will be very helpful.

Background Information (Basic Definitions)

What exactly is an estate? An estate is a legal entity that comes into being when a person dies. The purpose of the estate is to gather the decedent’s assets, pay the decedent’s debts and expenses, and distribute the remaining assets. The estate exists until all of the assets have been distributed to heirs or other beneficiaries.

The executor is the person named in the will to administer the estate. (If no will exists, if no executor is named in the will, or if the named party refuses to serve as executor, the court will appoint an administrator to perform the same functions.)

Form 1040 (Final Individual Tax Return)

The executor must file the final income tax return for the decedent for the year of death as well as any returns from prior years that have not yet been filed. (For example, if you die in February of a given year without yet having filed your return for the prior year, your executor will have to file your return for that prior year as well as the return for the year of death.)

The final tax return is due on the same date it would have been due if the death had not occurred (i.e., typically April 15 of the following year).

For the final return and any returns for prior years not yet filed, the executor may choose to file a joint return with the decedent’s surviving spouse, if applicable.

Form 1041 (Income Tax Return for the Estate)

The executor also must file an income tax return (Form 1041) for the estate for each year that the estate remains open. Broadly speaking, the estate has to pay tax each year on any income it earns that is not distributed to beneficiaries. Form 1041 is where all such income and distributions are reported and where the resulting income tax is calculated.

For calendar year estates, Form 1041 for each year is due April 15 of the following year.

Form 706 (Estate Tax Return)

Form 706 is the estate tax return. That is, it’s the return relating to the federal estate tax (filed once), whereas Form 1041 discussed above is the income tax return for the estate (filed every year until the estate is closed).

Form 706 is also used to report and calculate the tax on generation-skipping transfers.

Form 706 generally only has to be filed if one of two things is true:

  1. The gross estate, plus taxable gifts made during the person’s lifetime (i.e., gifts beyond the annual gift tax exclusion amount) exceed the applicable threshold ($12,060,000 for 2022), or
  2. The executor elects to transfer the deceased spousal unused exclusion amount to the surviving spouse.

If Form 706 must be filed, the executor must file by 9 months from the date of death, with a 6-month extension possible.

State Returns

In addition to the above, there will generally be forms to file at the state level as well (e.g., income tax return for the decedent, income tax return for the estate, and potentially an estate tax return if the state has an estate tax).

Financial Planning for the Possibility of Cognitive Decline/Dementia

A reader writes in, asking:

“Would you consider writing a column on options for protecting oneself from being taken advantage of in dotage if there are no children to take over the finances? We’ve done wills and named beneficiaries for all accounts. Is there a document or trust or process to hire a trustworthy professional when the time comes?”

Simplify and Automate

Firstly, while this is not exactly an estate planning tool, simplifying your finances (e.g., consolidating accounts, minimizing the number of investment holdings, automating payment of bills, etc.) can help minimize the impact of minor cognitive decline. It also makes things easier for anybody who might take over control of your finances, as discussed below.

Increasing the portion of your spending that is satisfied by automatic, guaranteed sources of income (i.e., Social Security and/or lifetime annuities) is also helpful for similar reasons. That is, once such sources of income are in place, they require no further decision-making — a marked contrast from the ongoing process of selling investment holdings to satisfy living expenses.

Durable Power of Attorney for Finances

A useful tool for planning for the possibility of dementia or other forms of cognitive decline is the durable power of attorney for finances. (Of note: I’m sticking specifically to financial concerns for the sake of this article, but a durable power of attorney for healthcare may be useful as well.) A power of attorney for finances is a document that appoints someone as your “agent” (sometimes referred to as an attorney-in-fact), and this person will have the authority to make financial transactions on your behalf.

A key point is that, in this context, it is critical that it is a durable power of attorney. A non-durable power of attorney automatically expires if you become mentally incapacitated, which is obviously a problem when mental incapacitation is precisely the concern we’re trying to address.

When drafting the power of attorney, it can be an immediate power of attorney (which grants the applicable authority to your agent immediately), or it can be a springing power of attorney (which only “springs” into effect if/when you become unable to manage your affairs due to disability or mental incapacitation). A springing power of attorney is safer in one sense (because it doesn’t grant anybody any authority until it’s necessary), but in some cases it can actually create problems.

There will generally be a specific event that must occur in order for a springing power of attorney to spring into effect (e.g., your physician must sign a document stating that you can no longer manage your own affairs). With dementia, there’s a big hazy area between “clearly mentally capable” and “clearly not mentally capable.” There’s often a stage at which a person is pretty “with it” on some days and much less so on other days. In short, there could be a point at which you could really use help, but your physician is not yet willing to sign that document — so your chosen agent cannot yet step in.

Another important point here is that some financial institutions will require their own power of attorney document to be filled out. (That is, they may not honor the power of attorney document that you and your attorney have prepared.) So be sure to check with your bank(s), brokerage firm(s), and so on in advance to see what they specifically require.

Develop Relationships Now

If you do not have a family member or friend whom you trust sufficiently to appoint to to be your agent, you can appoint a paid professional (e.g., an attorney, CPA, or CFP whom you trust).

Be aware, however, that most attorneys, CPAs, and CFPs do not provide such services, because a) doing so is quite a bit different from the typical services offered by such professionals, and b) taking on the role of being somebody’s agent comes with a considerable list of liability concerns. So don’t just expect your current attorney/CPA/CFP to be willing to take on that role when the time comes.

Instead, you will probably have to find a professional who specializes in this sort of work. Fortunately, such people/firms do exist. For instance, if you live in Chicago, you may want to begin with a search for: “eldercare CPA Chicago” or “professional fiduciary Chicago” (without the quotes).

A Few Final Notes

With regard to planning for potential dementia, if you have a living trust, it’s important to appoint a successor trustee, who can take over in the event of your incapacitation. It’s also important to note that a living trust is not a replacement for a durable power of attorney for finances, because the trustee’s authority is strictly limited to the assets within the trust. And some assets (most notably your retirement accounts while you are still alive) cannot be put in the trust.

Finally, with regard to everything above I would add that:

  1. It’s important to address these matters well in advance (i.e., while it is still quite clear to you and everybody else involved that you are still of sound mind), and
  2. It’s important to discuss these matters with an attorney who has expertise in estate planning.

What’s the Point of a Trust?

A reader writes in, asking:

“Can you explain succinctly what the point of a trust is? I had thought that they were a tool for avoiding estate taxes (I don’t understand how that works, but it’s not a concern for me) but my accountant suggested I create one and I don’t really understand why.”

There are many different types of trusts, each of which serves a particular purpose.

In most cases though, the overall idea is that a trust is a mechanism for exerting some control over how your assets will be managed after your death or incapacitation. That is, a trust is a legal entity which can a) hold assets and b) outlive you. So you can create a trust, fund it with assets, and write the terms of the trust in such a way as to stipulate certain requirements as to how the assets will be invested or spent — and then those rules will have to be followed even after you die or become incapacitated.

In order to better understand the various purposes for a trust, you need to know a bit of terminology.

Parties to a Trust

A trust involves three parties: the grantor, the trustee, and the beneficiary.

  • Grantor (sometimes called the donor or settlor): the grantor is the party who transfers property to the trust.
  • Trustee: the trustee is the party in charge of managing the trust (e.g., making investment decisions, distributing assets to the beneficiary when applicable, etc.). The trustee has a fiduciary duty to the beneficiary, and the trustee must manage the trust in such a way that is in keeping with the terms of the trust.
  • Beneficiary: the beneficiary (or beneficiaries) is the party for whose benefit the assets in the trust are held/managed.

Of note: these parties may be actual human persons, or they may be legal entities. For instance, you could name a law firm or CPA firm as the trustee to a trust. And it’s common to name a non-profit organization as a beneficiary of a trust.

Also of note: while there are three parties to a trust, one person may actually be in multiple roles — or even all three roles. For instance, you may be the grantor of a trust (i.e., you are the one funding the trust with your assets). And you may set it up so that you are also the trustee and beneficiary while you are alive, with your sibling being named as the successor trustee (i.e., the person who takes over as trustee after your death) and your child being named as the secondary beneficiary.

More Trust Terminology

A trust can be a living trust (also known as an inter vivos trust) or a testamentary trust. A living trust is a trust created by the grantor during his or her lifetime, whereas a testamentary trust is one created at the time of the grantor’s death. (That is, with a testamentary trust, the grantor’s will provides for the trust to be created and funded upon their death.)

A trust can be revocable or irrevocable. With a revocable trust, you can change the terms of the trust (or even terminate it completely) as long as you are alive and of sound mind. With an irrevocable trust, there are some exceptions, but you generally cannot make changes once it has been created.

Trust Usage Examples

With the above terminology out of the way, we can go through a few examples of cases in which a trust would be useful.

Example: Susie is a widow with three adult children (two daughters and a son). Her son has a long history of making poor financial decisions. In Susie’s will, rather than leaving 1/3 of her assets to each of her children outright, she leaves 1/3 to each of the daughters, and she leaves the remaining 1/3 to a trust. Susie names her son as the beneficiary of the trust, and she names her attorney as the trustee. This way her son still receives the benefits of the assets, but somebody else (the trustee) will be making the decisions as to how to invest and spend the assets.

Example: Luther and Harriette are married, in their 60s. Harriette has two adult children from a prior marriage. Luther does not get along with Harriette’s children. Harriette is concerned that if a) she dies before Luther and b) her assets are simply left to Luther at her death, he will ultimately disinherit her children. As a result, Harriette provides in her will for a testamentary trust to be created upon her death and for her assets to be placed into that trust. The terms of the trust are that Luther will receive the income from the assets while he is alive, and then the assets will be left to her children upon Luther’s death.

Example: Nigel and Veronica have an adult son who is disabled. The son is currently receiving Social Security disability benefits. And because of his low level of income and assets, he also qualifies for Supplemental Security Income (SSI) and Medicaid. If they simply leave their assets to him outright, he would lose eligibility for SSI and Medicaid. Instead, they create a special needs trust, which will receive their assets upon the death of the second spouse. Their son is named as beneficiary of the trust, and a trusted CPA is named as the trustee. Because the son has no control over the assets in the trust, it will not disqualify him from receiving SSI or Medicaid. The trustee will not be allowed to outright give the assets to the son, but the assets can be used for a variety of purposes for the benefit of the son.

And as the reader noted above, trusts are sometimes created with a goal of reducing potential estate tax costs. The general idea is to transfer assets to an irrevocable trust (thereby removing the assets from your taxable estate), often while maintaining some current benefit (e.g., the right to take income from the assets for a period of years). By transferring assets now, you will often have a taxable gift, but a significant advantage is that the gift is at today’s value, rather than at some more highly appreciated value at the date of your death. There are many different variations on this concept though (e.g., intentionally defective grantor trusts, qualified personal residence trusts, charitable remainder trusts, etc.).

In all cases with trusts, it’s critical to get expert guidance from an attorney who specializes in estate planning. If the attorney is not a tax expert, it will also be critical to get guidance from a tax professional with expertise in estate planning, as there are both income tax and estate/gift tax considerations involved with trusts.

What Is Estate Planning, and Do I Need to Worry About It?

When I recently asked for suggestions of specific estate-planning-related topics to write about, one thing that immediately became clear is that many people aren’t entirely sure what estate planning is — and whether it’s something they should be thinking about.

To put it bluntly, estate planning is planning for your incapacitation or death — choosing, for example, what will happen to your financial assets, your minor children, and your health care in such situations. As you can imagine, that’s a pretty broad field, and almost everybody has at least some degree of estate planning that they should be doing.

At the simplest level, estate planning would include making sure that the beneficiary designations on your retirement accounts and insurance policies are up-to-date. (Remember, it’s the beneficiary designation that controls where the money goes, regardless of what you say in your will.)

A very basic level of estate planning would also include making sure that you have a will that accurately reflects your wishes for any other assets (i.e., assets that do not pass directly to a named beneficiary outside of the will).

At a more advanced level of estate planning, some people will benefit from creating a trust to serve any of several different purposes. In short, a trust is a legal entity to which you would give some of your assets. Those assets are then managed by a person or entity whom you name (the “trustee”), for the benefit of some other person(s) or entity.

A trust can be helpful, for example, if there is somebody to whom you wish to leave assets, yet who you do not think should be put in charge of managing those assets (e.g., because of a disability or because of a well-established history of poor financial decisions).

Alternatively, trusts can be helpful for people on their second marriage. For example, imagine that you want to leave your assets to your new spouse, but you want to be sure that any assets remaining after that spouse dies go to your children from your first marriage (rather than to that spouse’s children from his/her first marriage). In such a case, you could put the assets in a trust, naming your spouse as a beneficiary to receive income from those assets for the duration of his/her life, and naming your children as beneficiaries who will receive those assets after your spouse’s death.

For some people, estate planning involves engaging in various activities to minimize the effect of estate taxes. This is, however, not a concern for most people these days, given the size of the federal estate tax exemption: $5.43 million in 2015, twice that for married couples.

Estate planning also includes several topics that are not strictly of a financial nature, such as choosing a guardian who will care for your children in the event of your death, or granting a medical power of attorney to a trusted family member or friend, so that he/she can make health care decisions on your behalf if you become incapacitated.

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