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 and the date of death entered on the name-and-address space. The filing deadline: April 15 of the year following the taxpayer's death.
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 it is received.
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" and is taxable either to the estate or to the person who receives it. Consider these examples.
- Joe Jones owned and operated an orchard. He used the cash method of accounting. He sold $2,000 worth of fruit to a customer but did not receive payment before his death. That amount is not reported on Joe's final return. When the estate was settled, payment had still not been made and the right to receive it went to Joe's niece. When she collects the money, she will report it as taxable income.
If Joe had used the accrual method of accounting, the $2,000 would have been considered earned on the date of the sale and therefore included on his final return. His niece would not have to include the money on her return when the payment was actually received.
- Mary Smith was entitled to a large salary payment at the date of her death, to be paid in five annual installments. Her estate collected two payments and then gave the right to the remaining three payments to her grandson. None of the income would be included on Mary's final return. The estate would include in its taxable income the two payments it received. Her grandson would include the other three payments in his taxable income - as income in respect of a decedent - on the returns for the years he received the money.
Income in respect of a decedent encompasses only income that the decedent had a right to receive at the time of death but that is not reported on the final return. It does not include earnings on savings or investments that accrue after death.
If a taxpayer who has a substantial amount in money-market mutual funds dies June 30, only dividends 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 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 Form 1099 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.
Remember that 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, it is considered income in respect of a decedent and is taxable on your return.
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, company 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.
There's a special rule for U.S. savings bonds, income on which generally accrues tax-free until the bonds are cashed. 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 the bonds.)
Alternatively, the interest accrued up to the date of death can be reported on the decedent's final tax return. That could be a tax-saving choice if the decedent will be in a lower tax bracket than the beneficiary. If that method is chosen, the person who gets the bonds includes in his or her income only interest earned after the date of death.
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 during the year the taxpayer died. Even if the death occurred on January 1, the full standard deduction is available. The same goes for the taxpayer's personal exemption.
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 the lower joint return rates. A joint return is usually filed by the executor, but the surviving spouse can file the return if no executor or administrator has been appointed.
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 generally must also complete and file with the final return a copy of Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer. But Form 1310 is not required if the person claiming the refund is a surviving spouse filing a joint return with the decedent, or a court-appointed or certified personal representative filing the original return for the decedent.
If the person filing the final return is the decedent's court-appointed representative, he or she must attach a copy of the form certifying the appointment. When a return calling for a refund is filed by anyone other than a court-appointed representative or a surviving spouse filing a joint return, Form 1310 must also be accompanied by a copy of the taxpayer's death certificate or other proof of death.
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