THEY DON'T GIVE YOU THE TOOLS
A sure path to frustration is being given a task, but not being given the tools needed to perform it. As an administrator of an estate, I experienced that frustration courtesy of the IRS.
The deceased was a family friend who named me in her will as her executor. I am an attorney, but that is not a requirement for being an executor. Her closest living relatives were a cousin, the spouse of a deceased cousin, and five children of another deceased cousin, spread out across the country.
More than gathering the estate's assets, paying the bills, and properly distributing the remaining estate, the executor’s primary concern today is getting the taxes right. Executors are personally liable for the estate's taxes. So, if the estate is distributed, and the IRS comes back later claiming that additional tax is due, the executor has to make good out of his/her own pocket.
The executor can ask the beneficiaries for reimbursement, but it is better for everyone if the executor gets it right the first time. In New Jersey, the executor has the right to obtain a "refunding bond" from the beneficiaries before making a distribution. The refunding bond makes reimbursement legally simpler, but chasing down beneficiaries, with or without a refunding bond, is still a giant headache.
Often, the beneficiaries have little interest in seeing that the taxes are paid properly. That’s not their job, and once they get their money, they can be reluctant to give any of it back. Of course, the more they’re asked to give back, the more reluctant they become. This divergence of interest between beneficiaries and executors can lead to a great deal of tension.
So, what taxes are involved? Most estates today are untouched by the federal estate tax because the estate tax applies only to estates valued at more than $12.92 million. To put that number in perspective, the U.S. Census finds the median household net worth in 2020 was $140,800. Even the 90th percentile of households had a net worth of only $1.41 million. The estate tax threshold of $12.92 million exceeds even the $10.4 million one must have to join the top-1% Club, according to Goldstone Wealth Management.
Although most estates pay no federal estate tax, many states impose state death taxes. For example, my estate's New Jersey Transfer Inheritance Tax was substantial because none of the beneficiaries was an immediate relative.
Even though most estates don’t pay the federal estate tax, the federal income tax affects everyone. Usually, the estate pays the decedent's final income tax and then an estate income tax from the date of death until the end of the year. That continues for each following year until the estate settles. The cycle becomes endless. The executor holds back enough of the estate to pay income taxes for the previous year, only to pay interest the following year on the amount held back. Usually, the estate’s accountant issues statements to the beneficiaries for the final year to make the beneficiaries personally responsible for the tax. Hopefully by then, the executor’s exposure is whittled down to the point where the risk of nonpayment of tax by the beneficiaries is insignificant.
But what happens if the IRS decides there was an error in the federal income tax return and demands an additional amount? Again, the executor is on the hook. Should the executor keep withholding funds to provide for IRS surprises and incur further tax liability on the interest? Unfortunately, there is no good answer to that question.
And here’s the final kicker. On another estate I handled, the financial advisor put the deceased into limited partnerships. The amounts were too small to make much tax difference, but the administrative headache was substantial. Most of you receive W-2 forms from your employer or 1099s from your bank, financial institution, broker, or the Social Security Administration. These forms tell you as a taxpayer how much income to declare. They are due to you in February, giving you plenty of time to prepare your income tax return.
For limited partnerships, it’s different. The equivalent form to the W-2 or 1099 is the K-1. K-1s aren't due until the middle of March and often do not arrive until the end of the month. (This year, I received one on April 1.) But without the K-1, the executor cannot prepare the return that’s due on April 15, and does not know how much tax to pay when requesting an extension.
If we had the FAIRtax today, executors like me could breathe more easily. Under the FAIRtax, there is no federal estate tax or federal income tax. Executors can concentrate on gathering estate assets, paying debts, and distributing the estate. The relationship between executors and beneficiaries would improve markedly.
If you ever handled an estate or a trust, I would love to hear how you dealt with the IRS.
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