So you think you can do the estate and inheritance tax returns for Mother’s estate by yourself? Maybe.
The forms for filing death tax returns look deceptively simple. They consist of a series of schedules for different types of property and deductions. Each schedule has a title at the top and then the rest of the page is left blank for you to list the property, deductions, and values. It’s your basic tabula rasa (for the Latin-challenged, a blank slate).
What goes on the schedules and how the value is determined is the important part. To know this you have to have a clear and detailed understanding of both the federal estate tax and the Pennsylvania inheritance tax regulations. In addition, there are lots of tax elections that can be made that will change the tax effect for estate tax, inheritance tax and income tax.
Making a plan to minimize estate, inheritance and income taxes for the estate is a complex matter. Let’s look at some of the elections just to give you an idea of the issues.
If the value of the estate declines, the executor may elect to value all assets as of the date 6 months after the date of death (or if disposed of at an earlier date, valued at the disposition date). This is called alternate valuation. It is available for the federal estate tax return but not the PA inheritance tax return. This means the same assets could be reported at different values on the two returns.
The executor may choose a fiscal year for the estate and may make an election to have the decedent’s estate and revocable trust taxed together as if they were one entity instead of two.
The executor chooses whether to take expenses of administration as deductions on the estate tax return or on the estate’s income tax return. Yes, Virginia, the estate has to file an income tax return too. While the assets are held in the estate, the income is taxable to the estate - which makes sense. The decedent is certainly not paying income tax any more, and the beneficiaries don’t have the money yet. The estate files a Form 1041 for federal income tax and Form PA-41 for Pennsylvania income tax.
The income tax rates that apply to the estate are the same as individual income tax rates except that the brackets are very compressed. An estate reaches the top bracket of 35% at just $9,950 of income while an individual doesn’t get to the highest 35% bracket until she has $319,100 of income. This difference in income tax rates often makes it desirable to distribute income from the estate to the beneficiaries during the course of administration. Then the income can be taxed at beneficiaries’ lower brackets. Planning for these distributions must take into account the estates fiscal year, liquidity, and the tax situations of the beneficiaries.
Similarly, when to close the estate and when to pay the administration expenses requires planning. This is an area where haste often causes more tax to be paid earlier.
There is another choice for the executor to decide whether to deduct payments for medical expenses on the decedent’s final 1040 or on the estate tax return.
For Series E Bonds the executor can elect to have accumulated interest taxed on the decedent’s final return or on the estate’s income tax return.
A election is available to qualify certain types of trusts for the marital deduction. This is called a “QTIP” election, not for the cotton swab, but for a “qualified terminable interest in property.”
The executor is responsible for filing the decedent’s final income tax return and the decedent’s final gift tax return, if one is due. There are elections available here, too. One of them is whether or not to “split” gifts with the surviving spouse.
For Pennsylvania inheritance tax there is an election for certain trusts called spousal sole use trusts, whether to pay the inheritance tax on the first spouse’s death or on the second spouse’s death. This election involves an actuarial computation based on the survivor’s life expectancy. .
Then there is the family farm. The estate may qualify for special use valuation which allows the farm to be valued, under certain conditions, as working farmland instead of at its highest and best use which may be for development. To elect the farm value, the beneficiaries must continue to use it as a farm for 10 years and meet other technical requirements.
It is quite a challenge for the executor and his attorney to figure out which combination of elections and options will produce the best overall tax result for the estate. Obviously, paying less in tax increases what the beneficiaries receive.
This list of elections is not exhaustive and is not intended to teach you how to do this on your own. Thanks to our Senators and Representatives, we have an extremely complex system of tax laws governing estates. Don’t try this at home - get professional help.