How to Deal With a Client’s Death in the Family

The IRS demands a final accounting, and it’s up to the executor or survivors to file the paperwork. Here’s what you need to know about the deceased’s final tax return, reporting income and deductions, inheritance, and more.

Federal Taxes

Death and taxes may be equally inevitable, but the taxman demands the last word. Death does not excuse a final accounting with the IRS. In fact, taxes can further complicate the lives of survivors. Depending on when the death occurred, federal estate taxes may be due, and state inheritance taxes could come into play as well. Our focus here will be on federal income taxes.

Final Tax Return

When a taxpayer dies, a new taxpaying entity – the taxpayer’s estate – is born to make sure no taxable income falls through the cracks. Income is taxed either on the taxpayer’s final return, on the return of the beneficiary who acquires the right to receive the income, or on the estate’s income tax return if the estate receives $600 or more of income.

The chore of filing the taxpayer’s final return usually falls to the executor or administrator of the estate, but if neither is named, a survivor must do it. The return is filed on the same form that would have been used if the taxpayer were still alive, but “deceased” is written after the taxpayer’s name. The filing deadline is April 15 of the year following the taxpayer’s death.

Reporting Income

Only income earned between the beginning of the year and the date of death should be reported on the final return.

For taxpayers who use the cash method of accounting, as most do, income is considered earned as it is actually received or at least made available to them. Taxpayers who use the accrual method of accounting, on the other hand, count income as earned when they actually earn it, regardless of when they receive it.

The distinction is important because some income that might logically seem to belong on the decedent’s final return is considered income in respect of a decedent (defined below), and is taxable either to the estate or to the person who receives it.

Earnings and Income

Income in respect of a decedent refers to income that the decedent had a right to receive at the time of death, but that is not reported on his or her final return. It does not include earnings on savings or investments that accrue after death.

Say a taxpayer who has a substantial amount in money-market mutual funds dies on June 30. Only interest earned up to that date would be reported on the final tax return. Earnings after that date are taxable to the beneficiary of the account, or to the estate.

That can create some hassles since the payer – a mutual fund, bank or broker, for example – will report income to the IRS on a 1099 form. Although you should try to get ownership of the account changed as quickly as possible after the death of the owner, the 1099 income report may well show more income assigned to the decedent than it should. In such cases, you must report the entire amount on Schedule B of the decedent’s return, and then deduct the amount that is being reported by the estate or other beneficiary who actually received the income.

Money you inherit is generally not subject to the federal income tax. If you inherit a $100,000 certificate of deposit, for example, the $100,000 is not taxable. Only interest on it from the time you become the owner is taxed. If you receive interest that accrued but was not paid prior to the owner’s death, however, it is considered income in respect of a decedent and is taxable on your return.

Inherited IRAs and Retirement Accounts

A major exception to the general rule that inheritances are not subject to the income tax – and one that is taking on more and more importance – is that money in traditional IRAs, employer-sponsored retirement plans including 401(k)s and 403(b)s, and annuities, is treated as income in respect of a decedent, and therefore taxed to the heir.

An important exception to this major exception covers Roth IRAs and Roth 401(k)s. No taxes are due on inherited Roth distributions, as long as the account had been open at least five years at the time of the owner’s death. If the original owner dies before the five-year period has elapsed, you can satisfy the holding period by rolling the account over into an inherited Roth IRA and waiting until the holding period has passed.

An important change took effect in 2007 that allows non-spouse beneficiaries who inherit a 401(k) to roll over that money into an inherited IRA, enabling them to spread out their distributions and associated tax bills over their lifetimes, just as spouses have always been able to do. Traditional 401(k)s and similar tax-deferred employer-sponsored retirement plans can be rolled over into traditional inherited IRAs. A beneficiary of a Roth 401(k) can roll over the funds into an inherited Roth IRA. Although Roth IRAs have no mandatory distribution requirements for the original owners, heirs must either withdraw all funds within five years of the original owner’s death or take annual minimum withdrawals over their lifetimes.

U.S. Savings Bonds

There’s a special rule for U.S. Savings Bonds, from which income generally accrues tax-free until the bonds are cashed in. When the bond owner dies, the accrued interest may be treated as income in respect of a decedent.

In that case, the new owner of the bonds becomes responsible for the tax on the interest accrued during the life of the decedent. (The tax isn’t due, however, until the new owner cashes in the bonds.)

Alternatively, the interest accrued up to the date of death can be reported on the decedent’s final income tax return. That could be a tax-saving choice if he or she is in a lower tax bracket than the beneficiary. If that method is chosen, the person who gets the bonds only includes in his or her income the interest earned after the date of death.

Reporting Deductions

On the deduction side of the ledger, all deductible expenses paid before death can be written off on the final return. In addition, medical bills paid within one year after death may be treated as having been paid by the decedent at the time the expenses were incurred. That means the cost of a final illness can be deducted on the final return even if the bills were not paid until after death.

If deductions are not itemized on the final return, the full standard deduction may be claimed, regardless of when the taxpayer died during the year. Even if the death occurred on January 1, the full standard deduction is available. The same goes for the taxpayer’s personal exemption.

Filing the Final Return

If the taxpayer was married, the widow or widower may file a joint return for the year of death, claiming both personal exemptions and the full standard deduction, and using joint-return rates.

The executor usually files a joint return, but the surviving spouse can file it if no executor or administrator has been appointed. (For the two years following a spouse’s death, the surviving spouse can file as a qualifying widow or widower. That basically lets you continue to use the same tax brackets that apply to married-filing-jointly returns.)

If an executor or administrator is involved, he or she must sign the return for the decedent. When a joint return is filed, the spouse must also sign. When there is no executor or administrator, whoever is responsible for filing the return should sign the return and note that he or she is signing “on behalf of the decedent.” If a joint return is filed by the surviving spouse, alone, he or she should sign the return and write “filing as surviving spouse” in the space for the other spouse’s signature.

If a refund is due, there’s one more step. You should also complete and file with the final return a copy of Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer. Although the IRS says you don’t have to file Form 1310 if you are a surviving spouse filing a joint return, you probably should file the form anyway to head off possible delays.

Basis of Inherited Property

For deaths that occurred in a year other than 2010, the tax basis of any property a taxpayer owns at the time of his or her death is “stepped up” to its date-of-death value. Since the basis is the amount from which any gain or loss will be figured when the new owner ultimately sells the property, this means that the tax on any appreciation that occurred during the taxpayer’s life is essentially forgiven.

The person who inherits the property – a house, say, or stocks and bonds – would owe tax only on appreciation after the time of death. It’s important that you pinpoint date-of-death value as soon as possible – the executor should be able to help – to avoid hassles later on when you sell it. If assets have lost value during the original owner’s life, the tax basis is stepped down to date-of-death value.

Survivor’s Home Sale Exclusion

In an important development for recently widowed spouses, a new law extends the period of time during which a surviving spouse may take up to $500,000 of home-sale profit tax-free, rather than being restricted to the $250,000 amount allowed for single homeowners.

Previously, a surviving spouse was entitled to the $500,000 exclusion only when he or she could file a joint return with the deceased spouse, which is available only for the tax year in which the spouse dies.

The law now allows the surviving spouse to use the $500,000 exclusion if the home is sold within two years of his or her spouse’s death.

 

This is one article in a series on life changes and tax. Check out other articles in the series here.