When we assist personal representatives in probates, we are often asked about taxes and tax filing requirements associated with probate. This post explains the possible tax filings that might be required as part of a probate process. When we represent clients in probates or trust settlements, we will work through these issues and give specific recommendations on each.
Estate Tax
The first potential tax we are often asked about is estate taxes. Estate taxes are a federal government tax on very large estates. Right now, each person can give up to $12 million to others tax free before the federal government will begin to charge any estate tax. This amount is set yearly and indexed for inflation and is currently set to go down to approximately $6.2M in 2025. Amounts over the $12M exemption amount are subject to tax, at rates of up to 40 percent. This amount is per person, so a married couple can leave $24M to their children without paying any estate tax under current law.
The estate tax affects very few people and is generally not a consideration in the probate cases we handle.
Decedent’s Income Tax
The second potential tax is income taxes owed by the decedent. Essentially, the decedent’s estate assumes the decedent’s income tax rights and obligations for the time she was alive. So, for example, assume a decedent was working and had investment income in 2021. If the decedent dies in June 2021, the personal representative will file an income tax return at the end of 2021 that will report all earnings and investment income received by the decedent in 2021 prior to death, just as if the decedent were still alive. Any tax due must be paid by the estate, and any refund due belongs to the estate. This is called the decedent’s final income tax return.
We typically recommend that our personal representatives work with the decedent’s tax preparer to determine if the decedent must (or should) file a final return and to assist with any filing. In most cases, a refund will be received when a decedent had significant earnings or pension income, since withholdings and tax brackets are based on a full year, but the decedent’s earnings will be less than expected since they did not live the full year.
Estate’s Income Tax
The final potential tax has to do with income earned by the estate. The best way to think about this is to understand that the IRS considers the estate to be a small business that exists to settle the decedent’s affairs, and that all income and expenses paid from the decedent’s date of death forward are part of that business. The beneficiaries are the owners of the business, and the personal representative is the manager. Like any other business, if the estate earned income, it must file a tax return and report its income (and expenses) on that return. The return is filed by the manager (the personal representative), but any taxes due are paid by the owners (the beneficiaries). This return is called a fiduciary return.
Some examples of income earned by an estate are:
The decedent owned a business or rental property that generates regular income after death.
The decedent owned stock that paid dividends after death.
The decedent owned stock that appreciated between his death and the date the personal representative sold it.
The decedent owned property with a deferred income tax component that is payable to the estate. U.S. Savings bonds, certain annuity payments, and traditional IRA accounts fall into this category.
Our clients are generally relieved to learn that most property of the decedent is principal, not income. So, for example, assume a decedent owned stock worth $100K at death, and the personal representative sold the stock for $105K. The $100K is the principal amount and is not taxable. The income is only the $5K of post-death capital gain. They are also relieved to learn that most costs of administration, including costs of sale on real estate and attorney’s fees, are deductible. This means that in most estates, the beneficiaries do not pay any tax. However, when the decedent owned property with a deferred income tax component, such as an annuity or IRA account payable to the estate, the deductions usually will not cover that income, and some tax will be paid by the beneficiaries on the excess.
Our practice with fiduciary returns is to arrange for that filing with a CPA who specializes in these types of returns. We work with our clients to make sure all income and expense properly appear on the estate’s accountings, the return is timely filed, and the beneficiaries are informed about any tax that might be on the horizon.
A Note on IRAs
Normally, qualified retirement accounts are paid by beneficiary designation, not through a probate estate. In that case, they go directly to the named beneficiaries, and do not pass through an estate or trust.
Most qualified retirement accounts (traditional IRAs, 401(k) accounts, and 403(b) accounts) are pre-tax money. (Roth IRAs are handled differently.) Pre-tax money means the owner of the account never paid any income taxes on the funds in the account when they were added to the account. Instead, the owner was planning to pay the taxes during retirement when the money was withdrawn. If the owner dies before withdrawing the funds, the beneficiary must pay the taxes, although they can be deferred to some extent. How long the beneficiary can defer taxes on an inherited IRA depends on the beneficiary’s age and relationship to the decedent, and is beyond the scope of this article.
Specific advice for beneficiaries inheriting IRA funds is tax and financial planning advice, not legal advice. The best strategy for minimizing taxes will vary based on the beneficiary’s individual circumstances, so we advise beneficiaries receiving significant IRA funds to work with a financial advisor and/or CPA who can help them minimize their tax burden on these accounts.
Questions and Next Steps
Have questions about this? Our office routinely assists personal representatives with probate and trust settlement matters. Call our office for a no obligation consultation.