A Primer on Fiduciary Income Tax.
This is one of the most common questions we receive and particularly so as we approach the heart of tax season. The answer is the classic lawyer response, “it depends.” After someone passes away, property is inherited in different ways and how the property is transferred (the ownership chain) impacts our fiduciary income tax analysis. This article will provide an overview of fiduciary income tax (the income taxation of a person‘s estate or trust assets), which is not to be confused with the PA inheritance tax or Federal estate tax (a one-time tax on the right to transfer property when a person passes away).
What Income Does an Estate or Living Trust Have to Report?
If there are income-producing probate assets that fund a person’s estate after death and the estate either sells the asset or earns taxable ordinary income (interest or dividends), then the estate is subject to income tax on the sale of the asset (step up in basis applies often minimizing or eliminating the gain) or the interest and dividends earned by the estate. The estate has its own Tax ID and the tax identification number for the probate assets will change from the decedent’s SSN to the Tax ID of the estate. Keep in mind that the initial funding of the estate does not trigger income tax (the exception to this rule would be a traditional retirement account or a deferred annuity that either names the estate as a beneficiary or does not have a beneficiary (often meaning that the estate is beneficiary by default)). However, the income that is earned on those assets is subject to income tax. Think about interest earned on cash, stock dividends, or the sale of asset (stock or real estate). These transactions will trigger a Form 1099 that reports the income to the estate.
A Living Trust is a probate avoidance vehicle that gets a Tax ID separate from the Grantor at the death of the Grantor of the Trust. The same reporting rules are applicable to a Living Trust as to a probate estate.
Tax Return Preparation Considerations
If an estate has over $600 of gross income during the year, the executor must file an income tax form called a Form 1041. The biggest difference between a Form 1041 and a Form 1040 is that an estate gets a deduction for distributions of income to its beneficiaries. This way only one entity/person – either the estate or the beneficiary, but not both – pays income tax on every dollar of income. The executor delivers to the beneficiaries an informational return called a K-1 that describes the nature of any income (or even a loss) that is distributed to the beneficiaries so that it can be reported on his/her personal income tax return. If there is any tax due by the estate (think capital gain), the executor is responsible for making sure the income tax is paid.
It is important that a beneficiary of an estate or trust does not file his/her personal income tax return until after the estate/trust completes its Form 1041 and issues the K-1(s).
Selection of a Fiscal Year or a Calendar Year
Keeping all of that in mind, an estate and/or trust may have a tax year different from the December end calendar tax year that we are used to for our personal taxes. An estate/trust may operate on a fiscal tax year that starts on the date of death and ends on the last day of the month before the one-year anniversary of death. For example, if a person passed away in July of 2023, then the estate will have a fiscal tax year that ends on June 30, 2024. The executor is required to file Form 1041 by Oct. 15, 2024 (the 15th day of the fourth month following the close of the tax year, or the next business day if a weekend or holiday).
To add to the complexity, if you are a beneficiary of a trust that was established for your benefit and the trust is ongoing in nature, then your trust will be operating on a calendar year basis. It is also possible that an estate could close its tax year early depending even if it would normally be on a fiscal tax year. So, all that being said, some trusts and estates may be operate on a calendar year basis and have the same April 15th filing deadline.
65 Day Rule – Opportunity to Distribute Net Income Within 65 Days After End of the Tax Year
It is important that executors/trustees review their income and distributions with their advisors at the end of the fiscal tax year. Fortunately, the IRS grants executors and trustees the option to treat distributions during the first 65 days of a tax year as made in the prior year; so, the trustee and his or her tax advisors do have a couple of months to get this done. During that review, they can figure out what the best results would be and structure the distributions to achieve them.
Be aware that once the 65 days have passed, distributions can’t be attributed back to the prior year. Any distributions will be required to be treated as occurring in the year they are made. Remember for fiscal tax years ending on December 31, 2023, distributions made through March 5th, 2024, can be treated as having been made in tax year 2023. The real benefit of the 65-Day Rule is that it provides options. When you are aware of options, you can make better decisions and achieve better tax results.
Let Us Help You
We are here to help! We have notified our clients of their year-end tax deadlines and obligations and continue to do so throughout the year when appropriate. If you or any other family members or friends have questions related to this topic, please contact us.
Tax Reporting for Assets Passing by Beneficiary Designation
Finally, as mentioned at the beginning of the article, you may have inherited assets as a designated beneficiary, which means the asset was transferred from the deceased person’s account directly to your account. In this scenario, the ownership chain is from the decedent (an account in his/her SSN) directly to you (under your SSN) and that transfer alone does not carry with it any income tax liability – it is the transfer of the principal amount. That being said, once you own the assets any future taxable activity associated with that asset is connected to you as the owner (just as any other asset that you own). So, if interest was earned or you sold a stock or made an inherited IRA distribution, then those transactions carry potential income tax liability that will be reported on a 1099 associated with your SSN.
Conclusion
Fiduciary income tax planning is challenging and requires knowledgeable support. Our firm draws upon decades of experience to advise and guide you on the best next steps to take when tax planning for your estate or trust. For questions about fiduciary income tax or the 65-Day Rule, please give our office a call or text us at (412) 419-1005 or email us at hello@pghestateplan.com.
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