Estate income tax during administration

Executors generally know a final personal return is required. Fewer know that the estate itself may need to file an income tax return, sometimes for several years.

The three possible returns

The final personal return, covering income from the start of the year to the date of death.

Filed on the normal schedule for the year of death, and a surviving spouse may generally file jointly for that year.

Any refund due can be claimed by the executor with the appropriate form.

The estate income tax return, covering income earned by the estate after death — interest, dividends, rent, and gains on assets sold.

Required where the estate's gross income exceeds a low threshold, or where there is a non-resident beneficiary.

The estate tax return, which is a transfer tax return rather than an income tax return, required only for larger estates or to elect portability.

The estate as a taxpayer

The estate needs its own taxpayer identification number, obtained from the tax authority, generally within days of applying.

This is required to open an estate bank account, which is itself essential — estate funds must never be mixed with the executor's own.

The estate can choose a fiscal year rather than a calendar year, which is a genuine planning opportunity.

Selecting a year end that spreads income across two tax years, or defers it, can reduce the total tax, and the election is made on the first return.

The rate problem

The reason this matters more than the amounts suggest.

Estates and trusts reach the top marginal income tax rate at a very low level of income — far lower than individuals.

Which means income retained in an estate is taxed heavily.

Income distributed to beneficiaries, by contrast, is generally taxed to them at their own rates, which are frequently much lower.

The mechanism is the distribution deduction: the estate deducts amounts distributed, and beneficiaries report the income on a schedule provided to them.

So distributing income to beneficiaries during administration generally produces a lower total tax than retaining it, sometimes substantially.

This is a real planning decision that executors frequently make by default.

What is and is not income to the estate

A distinction that confuses people.

Assets themselves are not income. Receiving the deceased's bank balance is not a taxable event.

Income earned after death is: interest, dividends, rent, business income.

Gains on assets sold are calculated from the date-of-death basis, which generally means small gains where sales occur promptly.

Income in respect of a decedent is a specific category: income the deceased was entitled to but had not received — a final salary payment, an outstanding invoice, or a retirement account distribution.

This is taxable to whoever receives it, without a basis adjustment, and a deduction may be available where estate tax was paid on the same amount.

Deductions available

Administration expenses, executor fees, attorney and accountant fees, and certain other costs.

Some of these can be claimed either on the estate tax return or on the income tax return, but not both, and the choice depends on which produces the greater benefit.

Where an estate has more deductions than income in its final year, excess deductions may pass through to beneficiaries.

The practical points for executors

Obtain the identification number early and open the estate account promptly.

Keep records of every receipt and payment from the date of death, categorised, since the return depends on them.

Watch the thresholds — the filing requirement arises at a low level of income and is easily crossed by an estate holding investments for a year.

Consider the fiscal year election on the first return, which cannot be changed afterwards.

Consider whether distributing income during the year produces a better outcome than retaining it.

Provide beneficiaries with their schedules promptly, since they cannot complete their own returns without them, and delays here are a common source of complaint.

Getting help

Estate income tax returns are not something most executors should attempt unaided.

An accountant experienced with fiduciary returns generally costs less than the tax saved through sensible elections, and the cost is an estate expense.

Penalties for late filing accrue, and the executor is responsible.

General information only, not tax advice. Thresholds, rates and elections change — consult a qualified tax professional experienced with fiduciary returns.