When someone dies, their estate becomes a separate taxpayer for income tax purposes. Estates are allowed to choose their tax year. We generally recommend that estates elect the longest fiscal year available, which is the end of the month preceding the one-year anniversary of the decedent’s death. For example, the latest fiscal year that can be elected for a decedent who dies in April of 2010 is March of 2011. The reason that we generally elect a fiscal year is to postpone the time when income taxes will be paid on income earned by the estate.
Revocable trusts are also allowed to make the same fiscal year election, though they are required to make a separate election (referred to as a Section 645 election) with the IRS.
Federal income taxes will be increasing for tax years beginning after December 31, 2010. The maximum rate for dividends will increase from 15% to 39.6%. The maximum rate for capital gains will increase from 15% to 20%. The maximum rate for rents and interest income will increase from 35% to 39.6%.
As a general rule, the estate or revocable trust pays taxes on capital gains and taxes on other income is paid by the beneficiaries to the extent the income is distributed, or paid by the estate or revocable trust if the income is retained.
If the estate retains the income, the estate will benefit from making a fiscal year election. If the estate or revocable trust intends to make distributions to the beneficiaries, and the beneficiaries are in a high income tax bracket, the estate or revocable trust may want to avoid a fiscal year election for decedents who die in 2010. The fiscal year election would cause the beneficiaries to pay higher taxes because the income will be taxed on their 2011 federal income tax returns.
There is a corollary problem for estates that already have fiscal years. If the estate is terminated in 2011 or later, the income will flow out to the beneficiaries in 2011, when it is likely to be taxed at a higher rate. Conversely, if the estate is terminated by December 31, 2010, the income will be taxed to the beneficiaries based on the lower 2010 rates. It is not always possible to accelerate the closing of an estate. However, if there are just a few minor details, it may be possible for the beneficiaries to assume responsibility for the final details in order to allow the estate to close.