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Filing Final Income Tax Return for Deceased Person: Mastering Allocations, Understanding IRD and More TUESDAY, SEPTEMBER 18, 2018 Darren J. Mills, Esq., CPA, ChFC, CLU, Atty Mills Elder Law, Red Bank, N.J. djmills1267@gmail.com
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
Compassion. Empathy. Responsiveness. Filing Final Income Tax Return for Deceased Person: Mastering Allocations, Understanding IRD and More Darren J Mills, Esq., CPA, ChFC, CLU
Agenda IRD/Income Calculations Special Income Issues Life Insurance; Stock Options; Basis Adjustments to Covered Securities; Sec. 199A Filing Requirements Elections/Personal Liability 6
IRD/Income Calculations 8
IRD/Income Calculations IRD All accrued income of a cash method taxpayer at the time of her death; All income of an accrual method taxpayer accrued solely as a reason of his death; and Contingent claim at the time of death whether cash method or accrual method. IRD is included in the income of the estate or of such persons when received by them whether or not they report income by use of the cash receipts and disbursements methods. Treas. Reg. 1.691(a)-2(a) Does not include items property includible in decedent s final income tax return. (Est. of Peterson v. Comm'r, 74 T.C. 630 (1980), aff'd 667 F.2d 675 (8th Cir. 1981); nor items excluded from gross income. 9
Common IRD: Compensation IRD/Income Calculations Earned but unpaid wages; bonuses and accrued vacation. Voluntary or contractual payments by a corporation to the decedent s estate in recognition of services. (Est. of Bausch v. Comm'r, 186 F.2d 313 (2d Cir. 1951), aff'g 14 T.C. 1433 (1950); 10
IRD/Income Calculations Common IRD: Interest Accrued interest of a cash method taxpayer Taxable to the person who acquires the right to receive the interest by bequest, inheritance or devise (Richardson v. United States, 294 F.2d 593 (6th Cir. 1961)) Interest attributable to a period after the decedent's death which becomes payable on the certificates of deposit after the decedent's death is not income in respect of a decedent, but is ordinary income includible in the gross incomes of the respective recipients under section 61(a) of the Code. Rev. Rul. 79-340 citing Rev. Rul. 64-104 11
Common IRD: Royalties IRD/Income Calculations Sale of manuscript by an author to publishing company in exchange for a royalty are considered earned by the author during her lifetime. Royalties due and accrued at the date of her death plus royalties after death constitute IRD. Rev. Rul. 57-544. C.f., license of a patent: royalties after date of death are not IRD (concept of license vs. a sale). Rev. Rul. 60-227. 12
Common IRD: IRD/Income Calculations Gain on the Sale of Property No IRD when the sale occurs after the shareholder s death. Treas. Reg. 1.691(a)-2(b), Ex. 4. Substantially completed performance under a binder contract prior to death with sale completed by executor after death constitutes IRD. Rev. Rul. 78-32. C.f., Substantive issues are present that could disrupt sale is not IRD. PLR 200744001. 13
IRD/Income Calculations Common IRD: Partners: The amount includible in the gross income of a successor in interest of a deceased partner under section 736(a) shall be considered income in respect of a decedent under section 691. IRC 753 S-Corporation: included in decedent s tax return. IRC 1367(b)(4); Pub. 559 IRA: A distribution to the beneficiary of a decedent's IRA that equals the amount of the balance in the IRA at the decedent's death, less any nondeductible contributions, is IRD under Code Sec. 691(a)(1) that is includible in the gross income of the beneficiary for the tax year the distribution is received. Parkers Tax Publishing. 59,120 14
IRD/Income Calculations Common IRD: Annuity: If the owner-annuitant of a deferred annuity contract dies before the annuity starting date, and the beneficiary receives a death benefit under the annuity contract, the amount received by the beneficiary in a lump sum in excess of the ownerannuitant s investment in the contract is includible in the beneficiary s gross income as IRD within the meaning of 691. If the death benefit is instead received in the form of a series of periodic payments in accordance with 72(s), the amounts received are likewise includible in the beneficiary s gross income (in an amount determined under 72) as IRD within the meaning of 691. Rev. Rul. 2005-30 15
IRD/Income Calculations Cont d Who is taxed on the gross income? Treas. Reg. 1.691(a)-2 Estate: if the right to receive the amount is acquired by the estate from the decedent; The person who, by reason of the death of the decedent, acquires the right to receive the amount, if the right to receive the amount is not acquired by the decedent's estate from the decedent; or The person who acquires from the decedent the right to receive the amount by bequest, devise, or inheritance, if the amount is received after a distribution by the decedent's estate of such right. 16
IRD/Income Calculations Cont d Income 1040 1040 1041 Individuals; Trusts; Estates; Corporations (S-Corps & BIG) 17
IRD/Income Calculations Cont d Example 1. The decedent was entitled at the date of his death to a large salary payment to be made in equal annual installments over five years. His estate, after collecting two installments, distributed the right to the remaining installment payments to the residuary legatee of the estate. The estate must include in its gross income the two installments received by it, and the legatee must include in his gross income each of the three installments received by him. Example 2. A widow acquired, by bequest from her husband, the right to receive renewal commissions on life insurance sold by him in his lifetime, which commissions were payable over a period of years. The widow died before having received all of such commissions, and her son inherited the right to receive the rest of the commissions. The commissions received by the widow were includible in her gross income. The commissions received by the son were not includible in the widow's gross income but must be included in the gross income of the son. Above two examples taken from Treas. Reg. 1.691(a)-2 18
IRD/Income Calculations Cont d Character of IRD Same as if decedent had received it (similar to the relation back doctrine of Arrowsmith which is commonly employed to distinguish between capital and ordinary income). 19
IRD/Income Calculations Cont d If the spouse dies during the year, the taxpayer is generally still entitled to a personal exemption for the deceased spouse. IRS Publication 17 Suspended losses from a PAL are allowed to the extent the losses exceed the amount by which the basis of the interest is increased at death under IRC 1014 (basis step-up). IRC 469(g)(2)(A) 20
IRD/Income Calculations Cont d Unused capital losses are generally lost. 21
IRD/Income Calculations Cont d Estate Income Tax Deduction A person who is required to include in gross income for any taxable year an amount of income in respect of a decedent may deduct for the same taxable year that portion of the estate tax imposed upon the decedent's estate which is attributable to the inclusion in the decedent's estate of the right to receive such amount. Treas. Reg. 1.691(c)-1 See Treas. Reg. 1.691(c)-1 and Pub. 559 for computation 22
IRD/Income Calculations Cont d Estate Income Tax Deduction Stock Options IRA Annuity Can claim a deduction for estate taxes owed but not yet paid. FSA 200011023 (not binding on Service). 1040: Misc. deduction not subject to 2%; Notice 2018-61 1041: Line 19 on return 23
Special Income Issues 25
Special Income Issues Life Insurance The Code provides that gross income generally does not include life insurance proceeds. IRC 101(a)(1). Exception: Transfer for Value ( TFV ) An absolute transfer for value of a right to receive all or a part of the proceeds of the policy. Exceptions to TFV: basis carryover transaction; a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder or officer 26
Life Insurance Special Income Issues Cont d Exception: Transfer for Value ( TFV ) Consideration: Not just money or tangible property. E.g., the creation of an enforceable contractual right to receive all or part of the proceeds of the policy may constitute a TFV Pledging or assignment as collateral is not a TFV 27
Stock Options Both NQSOs and ISOs are considered IRD but there can be differences. IRC 1014 does not apply to IRD. IRC 1014(c) NQSOs Special Income Issues Cont d Generally, OI when exercised (strike price FMV). 83(b) election. Substantial risk of forfeiture. OI = FMV amount paid. Taxed at grant or restricted property? 28
Stock Options NQSOs Special Income Issues Cont d Taxed at grant; 83(b) election No IRD since compensation taxed at grant. Transferee takes basis equal to FMV at date of death. Not taxed at grant IRD is inherent in the option and no basis step-up 29
Stock Options NQSOs Special Income Issues Cont d Restricted; no 83(b) election Compensation element remains open; therefore, IRD is present Money bequests should not be funded with NQSOs due to the potential presence of IRD; consider for charitable contributions 30
Stock Options ISOs Special Income Issues Cont d Exercised by the estate of the option holder or a person who acquired the option by bequest, inheritance or death of the option holder, the same favorable tax treatment applies as if the option holder was alive. Neither estate nor such person includes in income any amount as a result of the transfer of the stock pursuant to the option exercise; not IRD. 31
Special Income Issues Cont d Basis Adjustment: Covered Securities Covered securities are the following investments acquired after December 31, 2011: Stock in a corporation; Any note, bond, debenture, or other evidence of indebtedness; Any commodity (or contract or derivative with respect to such commodity) with respect to which the Secretary of Treasury determines that adjusted basis reporting is appropriate; and Any other financial instrument with respect to which the Secretary of Treasury determines that adjusted basis reporting is appropriate 32
Special Income Issues Cont d Basis Adjustment: Covered Securities Covered securities are the following investments acquired after a certain date: Stock in a corporation; Any note, bond, debenture, or other evidence of indebtedness; Any commodity (or contract or derivative with respect to such commodity) with respect to which the Secretary of Treasury determines that adjusted basis reporting is appropriate; and Any other financial instrument with respect to which the Secretary of Treasury determines that adjusted basis reporting is appropriate 33
Special Income Issues Cont d Under the cost basis legislation, the IRS has requirements for brokers on inherited shares. Rules require that if Schwab processes an estate and assets are distributed from an account fully owned by the decedent that Schwab step up the basis 100% to the date of death automatically. Inherited tax lots will be tagged as such and the holding period will be long term. If the decedent was a partial owner of an account ( i.e., JT TEN or Trust account), Schwab will not proactively step up the basis because the percentage owned by the decedent is not known and thus the percentage of tax lots to be stepped up is not known. If a step up is required, submit a request using Schwab s new Step Up Cost Basis to Date of Death Request Form, a copy of the client s Death Certificate and forward to your service team. When inherited shares are transferred between accounts, brokers must identify and flag the individual security as inherited. Inherited tax lots are treated as Long Term, regardless of the date purchased by the decedent, the date the securities were received from the estate, or the date the securities were sold by the owner. Cost Basis Procedures at Schwab, charles SCHWAB 34
Special Income Issues Cont d If an inherited security is transferred, the transfer statement will indicate it as such. If the inherited security is Covered, the transfer statement must provide the following: The Date of Death (DOD) as the acquisition date Adjusted basis equal to the fair market value (FMV) of the security on the DOD, unless the broker received instruction to use an alternate date (exactly six months from DOD). Equities If DOD falls on a trading day, the FMV is calculated using the average of the high/low of the DOD. If DOD falls on a non-trading day ( i.e., weekends or holidays), the FMV is calculated using the average of the high/low of the trading day PRIOR to and the average price of the of the high/low of the trading day AFTER the DOD. Example: Weekends Use the average of Friday s average price and Monday s average price. Holidays Assuming Monday is a holiday, use the average of Friday s average price and Tuesday s average price. Cost Basis Procedures at Schwab, charles SCHWAB 35
Special Income Issues Cont d Mutual Funds If DOD falls on a trading day, the FMV is calculated using the Net Asset Value of the DOD. If DOD falls on a non-trading day ( i.e., weekends or holidays), the FMV is calculated using the Net Asset Value of the trading day PRIOR to the DOD. Fixed Income If DOD falls on a trading day, the FMV is calculated using the average of the high and low price on the DOD. If DOD falls on a non-trading day ( i.e., weekends or holidays), the FMV is calculated using the average of the closing price of the trading day PRIOR to and the trading day AFTER the DOD. Cost Basis Procedures at Schwab, charles SCHWAB 36
IRC 199A Special Income Issues Cont d Estates: Calculation at the entity level. Prop. Treas. Reg. 1.199A- 6(d)(3) Under IRC 691(b) certain expenses for which the decedent was liable on the date of his death can be taken by: The decedent s estate; or If the decedent's estate is not liable, by the person who acquired by bequest, devise, or inheritance or by reason of the death of the decedent an interest in the property of the decedent that is subject to the liability 37
IRC 199A Special Income Issues Cont d The deductible expenses under IRC 691(b) are: IRC 162 Trade or business IRC 163 Interest IRC 164 - Taxes IRC 212 Production of Income 38
Filing Requirements 39
Filing Requirements [T]he term income in respect of a decedent [ IRD ] refers to those amounts to which a decedent was entitled as gross income but which were not properly includible in computing his taxable income for the taxable year ending with the date of his death or for a previous taxable year under the method of accounting employed by the decedent. Treas. Reg. 1.691(a)-1 Factors to consider Gross Income Filing Status Age Considered 65 the day before actual birthday 40
Factors to consider Gross Income Filing Status Age Filing Requirements Considered 65 the day before actual birthday 41
Filing Requirements Cont d 2018 Gross Income Filing Thresholds Filing Status Gross Income Single and under 65 $ 12,000 Single and 65 or older 13,600 Married filing jointly, under 65 (both spouses) 24,000 Married filing jointly, 65 or older (one spouse) 25,300 Married filing jointly, 65 or older (both spouses) 26,600 Married filing separately, any age* 0 Head of household, under 65 18,000 Head of household, 65 or older 19,600 Surviving spouse with dependent child, under 65 12,000 Surviving spouse with dependent child, 65 or older 13,600 42
Filing Requirements Cont d Treas. Reg. 1.6012-3(b)(1) Decedents. The executor or administrator of the estate of a decedent, or other person charged with the property of a decedent, shall make the return of income required in respect of such decedent. For the decedent's taxable year which ends with the date of his death, the return shall cover the period during which he was alive. Includes any unfiled returns. IRC 6012(b)(1) 43
Filing Requirements Cont d Due date the same as if death did not occur. Treas. Reg. 1.6072-1(d) Mark "DECEASED across the top of the return; include date of death Signature Personal representative if appointed as well as surviving spouse if a joint return No personal representative, surviving spouse on a joint return signs as follows: Filing as surviving spouse. 44
Purpose of Form Use Form 1310 to claim a refund on behalf of a deceased taxpayer. Who Must File Filing Requirements Cont d If you are claiming a refund on behalf of a deceased taxpayer, you must file Form 1310 unless either of the following applies: You are a surviving spouse filing an original or amended joint return with the decedent, or You are a personal representative (defined on this page) filing an original Form 1040, Form 1040A, Form 1040EZ, or Form 1040NR for the decedent and a court certificate showing your appointment is attached to the return. Example. Assume Mr. Green died on January 4 before filing his tax return. On April 3 of the same year, you were appointed by the court as the personal representative for Mr. Green s estate and you file Form 1040 for Mr. Green. You do not need to file Form 1310 to claim the refund on Mr. Green s tax return. However, you must attach to his return a copy of the court certificate showing your appointment. 45
Filing Requirements Cont d Purpose of Form Use Form 4810 to request prompt assessment of tax. Attach to your request the documentation requested on Form 4810. If you prefer to use your own format, your request must list the same information as requested on this form and include the applicable attachments. Specifically, you must verify your authority to act for the taxpayers (for example, letters testamentary or letters of administration) and provide copies of the authorizing document. Also, your request must clearly show: It is a request for prompt assessment under section 6501(d); The kind of tax and the tax periods involved; The name and social security number (SSN) or employer identification number (EIN) shown on the return (copies of the returns may be attached to help identify the return; write at the top of the return copy: COPY - DO NOT PROCESS AS ORIGINAL ); and The date and location of the IRS office where the returns were filed. 46
Filing Requirements Cont d When To File Do not file Form 4810 requesting prompt assessment until after you file the tax returns listed on the front of this form. You must submit a separate request for prompt assessment for any tax returns filed after this Form 4810. Where To File Send your request to the Internal Revenue Service Center where you filed the returns for which you are requesting prompt assessment. 47
Filing Requirements Cont d Section 6013(a)(2) provides that a joint return may be made for the survivor and the deceased spouse or for both deceased spouses if the taxable years of such spouses begin on the same day and end on different days only because of the death of either or both. The provision allowing a joint return to be made for the taxable year in which the death of either or both spouses occurs is subject to two limitations. Re-marriage Fractional tax-year due to change in accounting period 48
Elections/Personal Liability 49
Elections Qualified Revocable Trust ( QRT ) Election to treat QRT as part of the related estate during the election period A related estate is the estate of the decedent who was treated as the owner of the QRT on the date of the decedent's death. Treas. Reg. 1.645-1(b)(5) The election period is the period of time during which an electing trust is treated and taxed as part of its related estate. Treas. Reg. 1.645-1(b)(6) 50
Elections Cont d Qualified Revocable Trust ( QRT ) Executor The trustees of each QRT joining in the election and the executor of the related estate make an election to treat each QRT joining in the election as part of the related estate by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate No Executor Election made by the trustees of each QRT joining in the election, by filing Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate 51
Elections Cont d Qualified Revocable Trust ( QRT ) Irrevocable election Treas. Regs. 1.645-1(e)(1) PAL benefits One tax return: the estate Estate ability to elect a fiscal year 52
Personal Liability Discharge of Executor from Personal Liability for Decedent s Income and Gift Taxes Knowingly disregarding the debt owed the United States serves to impose liability on a fiduciary (Leigh v. Comm'r, 72 T.C. 1105 (1979); Forehand v. Comm'r, T.C. Memo. 1993-618). Executor was personally liable where the executor made mortgage payments on the decedent's residence, paid state income taxes due from the decedent, and paid debts to general creditors from the assets of the estate without satisfying the decedent's federal income tax liability. Rev. Rul. 79-310 53
Personal Liability Cont d Discharge of Executor from Personal Liability for Decedent s Income and Gift Taxes Executor can apply to the IRS for a release from personal liability. Upon receipt the IRS may notify the executor of the tax liability. If no response from the IRS within 9-months of receipt of application, the executor is discharged Form 5495, Request for Discharge From Personal Liability Under Internal Revenue Code Section 2204 or 6905 54