An Estate Tax Return is a legal document required according to federal and state laws, that reports the total value of a deceased person’s estate for tax assessment purposes. If the value of an estate exceeds the exemption threshold a return must be filed regardless of whether tax is due.
In this article we cover important information related to an estate tax return, and help you to understand what must be done to meet the legal obligations required of a deceased estate. Estate taxes can be complex and there are a number of issues we will highlight that you want to avoid. We recommend that you get professional help right from the start to wrap up a deceased estate in the most financially viable way while avoiding costly mistakes.
Thank you for your time. It’s our hope that we will make the task of dealing with your loved one’s estate a little easier on you by providing helpful and timely information.
Understanding Estate Tax Thresholds
Estate planning can be a complicated process, and when a loved one passes away, the executor faces a daunting task - particularly when it comes to tax obligations.
An estate tax return must be filed when the value of the estate exceeds the set threshold for a certain tax year. This federal estate tax threshold is currently set at $13,610,000. You have nine months to file estate tax returns or up to fifteen months by reason of an extension granted by the IRS. This extension can be gained by filing Form 4768 on or before the due date of the federal estate tax return. However, you should note that any taxes owed are still due by the original deadline.
This threshold includes nearly all assets, such as real estate, investments, retirement accounts, and even lifetime gifts made by the deceased. The executor of the estate must file the IRS Form 706 to report the estate’s value, even if no tax is ultimately due.
Even estates below the threshold amount may need to file if there is a specific reason, such as a portability election in which a married couple can shield up to $27.22 million.
What is a portability election?
An estate income tax return also must be filed if the estate elects to transfer any deceased spousal unused exclusion (DSUE) amount to a surviving spouse, regardless of the size of the gross estate or the amount of adjusted taxable gifts. The election to transfer a DSUE amount to a surviving spouse is known as the portability election.
This exemption covers the following assets:
Real estate
Stocks, bonds, and mutual funds
Retirement accounts
Personal property (e.g., vehicles, art collections, and jewelry)
Business ownership shares
If portability is not elected, the unused exemption will be lost. The election can only be made when you file a timely estate tax return.
Let’s consider the implications by way of an example. If one spouse dies with a $5 million estate (well below the exemption), the executor can file for portability to transfer the remaining $8.61 million of the unused exemption to the surviving spouse. If the surviving spouse then passes away with a $20 million estate, the estate could potentially avoid estate taxes on $13.61 million and $8.61 million (DSUEA).
You will know the exact amount of the DSUEA after the deceased spouse’s estate has been calculated and the federal estate tax return has been filed and processed. The DSUEA amount is subject to change if the estate undergoes additional review or audit by the IRS.
Additional filing considerations
While the federal estate tax exemption is quite high, many states have their own estate or inheritance taxes with much lower exemption limits. For example, Massachusetts and Oregon impose taxes on estates valued as low as $1 million. But thankfully, here in Texas, you will not owe the state any estate taxes.
A state estate tax return creates an additional layer of complication for executors, as state filing requirements may be triggered even when the federal estate is not required. Even if you live in the state of Texas, you may be required to file a return if the deceased owned property in another state with low exemption limits. If not handled properly, beneficiaries can unwittingly become liable for taxes they did not know about or expect.
Estate planning is truly something that must be done by a professional, like a CPA or estate tax professional. The idea of your spouse missing out on an exemption or your beneficiaries being liable for a large amount of tax is heartbreaking when you’ve done all you can to ensure they’re looked after if you pass.
Set up a consultation with an experienced tax planning and preparation firm like Hall Accounting Company before your estate is left footing a tax bill that you didn’t intend. Unexpected things happen quickly, and estate planning should not be one of those things that you keep putting off. Call us now.
Process of filing an estate tax return
The executor of the estate must prepare Internal Revenue Service Form 706, which requires detailed documentation of the estate’s assets and their appraised values. This process can be complicated and takes time, especially for larger estates that may include real estate, closely held businesses, or investment portfolios. Common sections of Form 706 include:
Gross estate valuation
The gross estate valuation is a critical step in determining whether an estate tax return is required and calculating any estate tax that may be owed. The gross estate includes almost everything the deceased person owned at the time of the decedent's death. This valuation is used to determine whether the estate exceeds the federal estate exemption threshold.
Here are the key categories of assets that contribute to the taxable estate.
Real estate - Includes any property the decedent owned, including the primary residence, vacation home, and any investment or commercial properties.
Financial accounts - This includes IRAs and 401(k)s. Similarly, checking accounts, savings accounts, and brokerage accounts are included. Stocks, bonds, and mutual funds must also be valued at their market price at the decedent’s date of death.
Life Insurance policies - A payout from life insurance policies is included if the decedent had control over the policy to change beneficiaries or borrow against the policy.
Business interests - If the decedent owned a business or held a share of a partnership, the value of that interest is included. A share of a partnership can be one of the most complicated parts of estate valuation since business appraisals are required to determine fair market value.
Debts owed by the decedent - If anyone owed money to the decedent, such as unpaid loans or promissory notes, those receivables are considered part of the estate value.
Gifts made during lifetime - Lifetime gifts that exceed the annual gift tax exclusion amount must be added back into the estate valuation if they were taxable. The objective of this is to stop people from giving away assets to avoid estate taxes before their death.
Valuation methods
To properly value the gross estate, the IRS allows two methods of valuation:
Date-of-death valuation: This is the most straightforward method and involves assessing all assets as of the date of the decedent’s death.
Alternative valuation date: The IRS allows the executor to choose an alternate valuation date, which is six months after the date of death. This can be advantageous if the value of the estate’s assets has decreased within that six-month period, as it would reduce the estate’s tax liability.
Possible deductions from the gross estate
After calculating the gross estate, several deductions can be taken to reduce the taxable estate.
Debts and mortgages
Estate administrative and funeral expenses
Marital deduction
Charitable contributions
There may also be other deductions that apply which are unique to your personal situation. An experienced tax professional can help you with these deductions, and it would be a smart move to find someone who has experience with estate tax so that you don’t miss out on any deductions and end up paying more tax than you need to.
By consulting a tax professional, you will also avoid the pitfalls associated with estate tax return filing. Let’s discuss these next.
Mistakes to avoid when filing estate tax returns
Missing out on spousal unused exclusion
Losing a loved one is a very stressful event, and understandably, the payment of taxes and the need to file an estate tax return is not first on the list of priorities. However, important extensions and deadlines can come and go when you don’t understand what is needed to finalize your loved one’s finances with the federal government.
This is why you should appoint an executor for the estate long before you ever think it’s necessary to do so, and let someone else who isn’t grieving and emotionally attached to the decedent's assets handle the legalities. We’ve discussed unused spousal exclusion already, but this is a critical exercise that you don’t want to miss out on. It can greatly help you retain as much of your loved one’s estate as possible.
Undervaluing estate assets
Gathering the necessary documentation to establish a correct valuation takes time, especially if there is a business involved. It may also be tempting to believe that gifting assets would be a way for others to receive their inheritance tax free, or reduce estate tax liability, but this is not a mistake you want to make.
Remember that the IRS is given additional financial information through credit bureaus, financial institutions, and insurance companies. If the IRS determines that the assets you’ve declared don't match official documents, they will audit the estate. This can lead to delays, interest, and penalties.
The objective of the estate executor will be to get an estate tax closing letter as soon as possible, that will signify the closure of an estate’s tax matters. However, unintentional mistakes will cause a delay in this process coming to a conclusion.
What is an estate tax closing letter?
This is a document issued by the IRS that signifies the closure of an estate’s tax matters. It confirms that the IRS has reviewed and accepted the estate’s federal estate tax return (Form 706) and that no further information or payments are required.
Since 2015 this letter is no longer automatically issued. Instead, executors must request an estate closing letter through the IRS by submitting form 4506. The IRS will issue this letter 4-6 months after the estate tax return is submitted.
Some companies and financial institutions require this letter as part of their procedures for closing accounts or transferring assets. If there are time constraints, executors can also request an account transcript from the IRS. The account transcript provides a summary of the status of the estate tax return.
In Closing
In this article we have discussed a number of issues pertaining to filing an estate tax return. You should file a return even if there is no tax due, but the value of the estate exceeds the federal threshold, or you intend to apply for unused spousal exclusion.
Because the matter of finalizing a deceased estate can be difficult, complex, and confusing at a time when there’s already a lot to deal with, it makes good sense to hand over estate administration to a professional.
Living estate tax planning - a gift for the future
If you have a sizable estate, you don’t want to leave anything to chance. Taking the burden of tax obligations away from your spouse and other legal heirs is the best gift that you can give them. Speak to us today and let us help you plan your taxes so you can make sound decisions that will help your loved ones in the future.