Income tax issues for estates.

• Author: Keene, David
• Position: Part 1

This two-part article focuses on some distinguishing features of the taxation of estates. A decedent's death may trigger the filing of estate tax (Form 706) and/or estate income tax (Form 1041) returns. Tax advisers need to familiarize themselves as to which deductions can and should be taken on which return, to maximize tax savings.

Advisers familiar with the income tax rules for individuals can encounter problems when working with estates. Although the income taxation of estates is similar in many ways to the roles applicable to individuals, there are differences--some obvious, others subtle. Familiarity with these differences will avoid tax problems or permit tax savings.

This article focuses 6n some distinguishing features of estate taxation. Part I, below, centers on income tax issues that often arise during the probate process, with an emphasis on deciding between estate and income taxes. Part II, in the next issue, will examine maximizing tax benefits by timing deductions and distributions.

Understanding the Process

After a death, the estate administration process governs the tax adviser's efforts. Incomplete understanding of this process will increase the time spent on postmortem tax planning and return preparation and increase the likelihood of mistakes.

When an estate is created, the probate process begins in a local court.(1) An executor's first task is to determine the estate assets and liabilities, which can be time-consuming. The executor then must carry out the instructions in the decedent's will. While following these instructions, the executor has a fiduciary responsibility to preserve and maintain estate property until the estate's liabilities are settled and all property is distributed to the beneficiaries. The tax adviser's role in this is as follows:

1. Determine the estate's assets and liabilities. These will be reported on Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return, and also on any state inheritance tax return. The assets must be valued and described in detail and the form of ownership determined.

2. Estate property will usually generate income and expenses during administration, requiring the preparation of Form 1041, U.S. Income Tax Return for Estates and Trusts.

3. As administration progresses, property will be distributed to the beneficiaries. As is discussed in Part II of this article (in the February 2001 issue), the timing of such distributions can have a dramatic effect on the estate's or beneficiaries' income tax expense.

4. The income tax basis of distributed property will generally be its date-of-death (DOD) value or alternate valuation date value (six months after the DOD).(2) This basis information needs to be given to beneficiaries for use in their income tax calculations.

   Logic dictates that a complete and accurate determination of all estate assets and liabilities be made before gathering income and expense information for income tax purposes. This approach can be thwarted if the tax professional responsible for completing Form 706 differs from the one preparing Form 1041. Communication and information sharing ensures the successful and efficient completion of both returns in such situations. Some deductions can be taken either as estate tax deductions on Form 706 or as income tax deductions on Form 1041. Such choices may have a significant effect on the total tax burden; thus, cooperation between tax professionals is critical:

   * The Form 706 preparer should supply asset and liability information as it is being gathered to the Form 1041 preparer. If the former waits until Form 706 is complete before sharing such information, tax planning opportunities may be lost, such as the ability to choose an optimal tax year-end or minimize the estate's overall tax burden.

   * The Form 1041 preparer should immediately begin an accounting based on the first draft information of the estate's assets and liabilities. At a minimum, this will require obtaining bank and securities statements from the DOD forward. By taking an accounting from the initial information, the Form 1041 preparer will likely find sources of income not traceable to known assets or estate administration expenses not originally picked up on Form 706. This new information can then be shared with the Form 706 preparer.

   * Teamwork and communication are the key to benefiting a client.

   What Is An Estate?

   Besides working with the probate process and engaging in productive teamwork, a tax adviser needs to understand the tax consequences flowing from the form of ownership of estate property.

   A fundamental ownership concept is the...