Taxing a Probate Estate

There is an old saying that only two things are for certain, death and taxes. These two concepts are very real with respect to trusts and estates. The California Probate Code is a series of laws that contemplate what happens upon a person’s death. With death come various tax liabilities.

Just as an individual who produces income has a concurrent tax liability, an estate that produces income is also liable for taxes. This post will discuss some of the implements of an estate’s income tax requirements.

Taxes on Entities

Upon a person’s death, he or she creates a legal entity called an estate. The estate is distinct from the person the same way an incorporated business is distinct from the person. Just as a human-owned corporation has tax liability, so does an estate.

Estate as an Entity

As mentioned, an estate is an entity and may be liable for taxes. An estate, in contrast to a business that can be perpetual, has a finite timeframe. The estate is a legal entity from the death of the testator until a final distribution per a California probate court. As a legal entity, it has its own character that is distinct and separate from the beneficiaries. Upon distribution of assets, the estate ceases to exist as a legal entity and is therefore no longer required to pay taxes.

Tax Liability

Similar to a person or business, tax liability of an estate is only for revenue generated. This often comes from investments that the testator made during his or her lifetime. For instance, the testator may have been an investor in a mutual fund that provides fixed income payments for a specific number of years. If the testator passed during that time, the fixed income payments will continue to the estate. The estate would be responsible for taxes against those payments.

Another scenario in which income tax may be a significant factor is when a potential beneficiary of the estate wants to sell the testator’s house. A previous post provided specific facts regarding how one may sell a property during probate. Note that while market conditions may favor the sale of the testator’s home, tax implications may give beneficiaries second thoughts. If market conditions are good for property sales and the testator did not live in the house for long, or if the house was a second home, then the sale of that house or property would be subject to capital gains taxes. Capital gains taxes could amount to 20% of the sale price less the basis price.

Often, California probate courts will hear arguments on this subject, i.e. whether it is proper to sell the property because of a strong housing market versus tax liability for capital gains. In the event that potential beneficiaries sell the property and there is a gain on the sale of the property, the estate will be obligated to pay income tax against those gains.

Filing a Tax Return

Similar to a human who provides tax information via filing a tax statement, the estate of a deceased person is also obligated to file a tax statement on its behalf to report its income during the course of a year. In contrast to the average taxpayer that files taxes per a calendar year, an estate has an option of choosing a calendar year or a 12-month timeframe. That is to say, an estate can choose a calendar year and must file by April 15th, similar to all taxpayers. If the estate came into being in December and chooses the calendar year timeframe, it would have an April 15th deadline. If it chooses a 12-month timeframe, it would pay taxes for the 12 month time period starting from when the estate was created. Its tax filing deadline would not be April 15th; instead, the deadline would be the 15th day of the fourth month from when the counting starts.

When filing, the executor files a form 1041. The 1041 tax return is similar to the basic 1031 tax form. An estate has a $600 threshold, meaning that it is not taxed on the first $600 it earns, but is taxed on all amounts earned above that amount.

If an estate wants to file for a five-month extension for when it must pay taxes, it would file a Form 7004.

Are you considering drafting a will? Speak with an experienced Oakland trusts and estates lawyer. Speak with the law firm of Melanie Tavare.