The following are some selected highlights of a decedent’s final tax return that deserve special attention. You should seek competent advice.
The decedent’s final taxable year ends on the date of death and the tax ‘year’ could be relatively short. Regardless, the decedent is allowed a full personal exemption under IRC section 151 and in the case of a non-itemizer, a standard deduction under section 63.
US savings bonds: Normally, the decedent’s income is reported under the cash method. In this case, interest on the saving’s bonds is not included in the return unless the bond has matured, redeemed or otherwise disposed of. The personal representative of the decedent can, however, elect to to report the accrued interest until they date of death in the final return. This may lead to tax savings if the decedent’s marginal tax rate is relatively low. See Section 454: reporting U.S. savings bonds owned at death.
Interest in partnerships, S corporations, estates and trusts: The death of an S corporation shareholder may cause a corporation to lose its S status if the decedent’s stock passes directly from the decedent to a successor who is not a permitted shareholder. Does my Company Lose its S-Corp Election if a Shareholder Dies? There are other potential negative tax consequences which can be mitigated with proper planning: Avoiding an Adverse Tax Impact on Death of an S Corporation Shareholder
Medical Expenses: The IRC allows deduction for unreimbursed medical expenses if they exceed 10% of adjusted gross income. Many bills, however, arrive after the date of death of the decedent. A special rule allows inclusion of medical expenses paid by the estate within 1 year of the date of death Reg. 1.213 – 1(d)(1) into the decedent’s tax return. When this election is being made, the estate cannot make the otherwise allowable deduction on the estate’s tax return (Reg 1.213 – 1(d)(2).
Charitable deductions, losses and carryovers. Excess contributions can generally be carried forward for up to 5 years , but this carryover expires with the decedent. In other words, deductions can only be made on the final year up to the percentage limit.
Suspended passive activity losses. Death suspends all activities. The IRS defines passive activities as follows: “Passive activities include trade or business activities in which you don’t materially participate. You materially participate in an activity if you’re involved in the operation of the activity on a regular, continuous, and substantial basis. In general, rental activities, including rental real estate activities, are also passive activities even if you do materially participate.” Topic No. 425 Passive Activities – Losses and Credits. A taxpayer can claim a passive loss against income generated from passive activities; however, a passive loss cannot be claimed against active income. On the decedent’s final tax return the amount of the suspended loss allowed as a deduction is reduced by the step-up in basis for the related asset to fair market value (FMV) the transferee of the suspended activity enjoys. If this were not so, taxes would be avoided twice.
Example: “The taxpayer owns a rental property. The building has an adjusted basis of $500,000, a fair market value of $550,000, and passive suspended losses of $75,000. The taxpayer does not have any other passive income. If the taxpayer dies during the tax year, the deductible suspended passive loss on the taxpayer’s final income tax return will be limited to $25,000 ($75,000 ‒ $50,000 step-up in basis).” Planning opportunities for the final tax return.
Annuities. Annuity payments can be conceptualized as a pro-rata return over the life expectancy of the paid in principal plus investment returns. Only the investment returns are taxable, the returned principal has already been taxed once before. What is taxed per annuity payment is based on the exclusion ratio, calculated by the annuity provider and explained here with examples: Annuity Exclusion Ratio. However, if the annuitant outlives her life expectancy, she has a ‘mortality gain’, and an exclusion ratio is no longer applied. She pays taxes on all distributions beyond her life expectancy. Conversely, mortality losses are deductible on the tax return.
Joint return. Filing a joint return may allow the use of the decedent’s excess deductions or loss carryovers by offsetting against the surviving spouses’s full year return. The executor is normally the only person who can file a joint return on the behalf of the decedent.
