A loved one who was “financially comfortable” has passed away. What happens now tax-wise? Good question, especially if you’re the one responsible for taking care of financial matters. This column is the first installment of a three-part series covering the most important tax-related considerations when a loved one departs.

The role of the executor

When a loved one (the decedent) passes away, someone must tackle the job of handling the resulting tax issues. That person may be identified in the decedent’s will as the executor of the decedent’s estate. If there’s no will, the probate court will appoint an administrator. Either way, let’s just call that person the executor to keep it simple. That person may be you. If so, not so simple for you. So please pay close attention.

The executor’s job is to identify the estate’s assets, pay off its debts, and distribute the remainder to the rightful heirs and beneficiaries.

The executor is also responsible for filing any necessary tax returns and arranging to pay any taxes. So let’s start covering those bases.

Filing the final Form 1040

If the decedent was unmarried, the final Form 1040 covers the period from January 1 though through the date of death. The final return is prepared in the usual fashion. It is due on the standard date: 4/15/20 for someone who dies in 2019. The return can be extended for six months, to October 15 (adjusted for weekends and holidays) of the year after the year of the decedent’s death.

Side note: How to handle final medical expenses for taxes

Pay special attention to the decedent’s medical expenses. If large uninsured medical expenses were incurred in the year of death, the executor must make a potentially important choice about how they are treated for federal tax purposes. Along with any medical expenses paid before death, the executor can choose to deduct accrued (as-yet-unpaid) medical expenses on the decedent’s final Form 1040 to the extent they exceed 7.5% of adjusted gross income (AGI) for 2018 or 10% of AGI for 2019, assuming the decedent’s final Form 1040 claims itemized deductions.

To take advantage of this special rule, the medical expenses must be paid out of the decedent’s estate during the one-year period beginning with the day after the date of death. This special rule is an exception to the general rule that expenses of a cash-basis taxpayer must be paid in cash before they can be deducted. Final medical expenses can easily exceed the percent-of-AGI threshold, especially when death occurs early in the year before much income has been earned.

Alternatively, in the relatively unlikely event that the estate is subject to the federal estate tax, the executor can choose to deduct accrued medical expenses on the estate’s federal estate tax return rather than on the decedent’s final Form 1040. When no federal estate tax is owed, this is obviously not an option. The federal estate tax exemption for someone who died in 2018 is $11.18 million. It is $11.4 million for someone who dies in 2019.

Key Point: When federal estate tax is owed, deducting accrued medical expenses on the federal estate tax return is usually the tax-smart option. That is because the estate tax rate is 40% while the decedent’s final federal income tax rate could be as low as 10%. Also, the full amount of accrued medical expenses can be deducted on the estate tax return (not just the excess over the percent-of-AGI threshold).

Surviving spouse can usually file joint return for year of death

When there is a surviving spouse who remains unmarried as of the end of the year that includes the decedent’s date of death, the final Form 1040 can be a joint return filed as if the decedent were still alive. This final joint return includes the decedent’s income and deductions up to the time of death plus the surviving spouse’s income and deductions for the entire year. Filing a joint return is usually beneficial, because it allows the surviving spouse to take advantage of the more taxpayer-friendly rates and rules that apply to married joint-filing couples.

If the surviving spouse remarries on or before December 31 of the year that includes the decedent’s date of death, married filing separate status must be used for the decedent’s final Form 1040.

Surviving spouse may be able to use joint return rates for two more years

The tax-rate advantage of joint filer status is extended to a qualified widow or widower for the two tax years following the year that includes the decedent’s date of death.

To be a qualified widow/widower for the year, the surviving spouse must be unmarried as of the end of that year. The surviving spouse must also pay more than half the cost of maintaining a home that is the principal home for the entire year of a child of the surviving spouse (including a step-child) who qualifies as a dependent of the surviving spouse. Finally, the surviving spouse must have been eligible to file a joint return with the decedent for the tax year that includes the decedent’s date of death.

New Law Impact: The Tax Cuts and Jobs Act suspended dependent exemption deductions for 2018-2025. However, for purposes of various provisions that make reference to persons for whom dependent exemption deductions are allowed (such as the aforementioned eligibility rule for qualified widow/widower status), the dependent exemption is still deemed to exist for 2018-2025. It just equals $0 for those years. Strange but true!

If decedent had revocable trust

To avoid probate, many individuals and married couples of means set up revocable trusts to hold valuable assets including real property and financial accounts. These revocable trusts are often called living trusts or family trusts. For tax purposes, these trusts are so-called grantor trusts. As long as the trust remains in revocable status, it is a grantor trust and its existence is disregarded for federal tax purposes. Therefore, the grantor or grantors are treated as still personally owning the trust’s assets for tax purposes, and tax returns of the grantor(s) are prepared accordingly.

Unmarried individual’s trust

When an unmarried individual passes away, his or her grantor trust becomes irrevocable. As such, the trust is now treated as a separate taxpayer that is subject to the federal income tax rules for trusts. This is an unfavorable development, because the tax rates on undistributed trust income quickly climb to the maximum 37% rate for ordinary income and short-term capital gains and the maximum 20% rate for long-term capital gains (LTCGs) and qualified dividends. (See the section above about medical bills.) If the 3.8% net investment income tax also applies, the marginal federal rate on a trust’s undistributed investment income and gains can be as high as 40.8%/23.8%. Ouch!

Married couple’s trust

For married couples, grantor trusts typically continue to exist as such when the first spouse passes away. In that case, the trust’s existence continues to be disregarded for federal tax purposes, and the surviving spouse’s tax returns are prepared without regard to the trust. However, when the surviving spouse passes away, the trust becomes an irrevocable trust. As such, it is treated as a separate taxpayer with the unfavorable federal income tax consequences mentioned above.

Tax planning goal with trusts

To avoid the unfavorable federal income tax rates for trusts, it’s generally a good idea to get the income and gains out of the trust by either distributing them to the trust beneficiaries or by winding up the trust.

The bottom line

When an unmarried individual passes away, the important federal income tax considerations explained here can apply.

When a married individual passes away, the surviving spouse can often step into relatively favorable federal income tax rules. However, important timing considerations may apply.

In either scenario, you as the person responsible for handling tax matters may want to hire a professional to prepare returns and help you identify and implement tax-saving strategies for the future. Honestly, you probably need all the help you can get.

The 2019 federal income tax rate brackets for trusts are as follows.

Rate brackets for ordinary income

10% tax bracket                $0 – $2,600 
Beginning of 24% bracket           $2,601
Beginning of 35% bracket             9,301
Beginning of 37% bracket          $12,751

Rate brackets for LTCGs and dividends

0% tax bracket                 $ 0 – $2,650 
Beginning of 15% bracket            $ 2,651 
Beginning of 20% bracket         $12,951

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