The Dangers Of Distributing Estate Assets Too Soon

Many estate executors focus on estate taxes and forget about income taxes. That can be an expensive mistake.

An estate is subject to income taxes much like an individual is. The estate must file an annual income tax return for every calendar year it is open for at least part of the year. This is separate from the estate tax return. The estate tax return is based on the value of the property in the estate. The estate income tax return reports the income received and deductible expenses paid during the calendar year. Only one estate tax return is due, but an estate income tax return is due for each year the estate was open.

Many executors distribute income to estate beneficiaries as it is received by the estate. This ensures the estate doesn’t owe taxes on the income. The estate takes a deduction for income distributed to the beneficiaries in the same year it is received by the estate, and the beneficiaries include the distributions in their gross income.

But if the estate doesn’t distribute income before the end of the year, the estate is taxable on it.

In addition, sometimes an executor receives some unexpected income or is surprised by the tax effects of some transactions. In these cases, the estate owes income taxes. Sometimes this happens after the estate has distributed all of its assets. In that case, the estate still owes the income taxes and the executor can be personally responsible for paying the taxes.

For example, some of the expenses the estate pays might not be deductible on the income tax return. If the executor assumes they were deductible and doesn’t realize the mistake until after the estate has been distributed, the estate will have an income tax liability but won’t have the cash to pay because all the remaining assets have been distributed.

Another fairly common situation is the estate receives property that is taxable as income if it isn’t distributed to beneficiaries. A stock dividend is a good example. The estate receives stock, and it is taxable income based on its value on the date of the distribution.

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But suppose the estate doesn’t distribute the stock to the beneficiaries until later in the year. In the meantime, the value of the stock declines.

When the estate tax return is prepared, the estate has to recognize income equal to the stock’s value on the date the stock was received. But it deducts only the lower value of the stock on the date it was distributed to beneficiaries.

The estate is liable for income taxes on the difference, though it might have distributed all its assets.

Those are just a few examples of how an estate executor can be surprised by an income tax liability with no cash to pay it.

The best advice for executors is to retain some cash until after the final estate income tax return is filed to ensure that is cash to pay any income tax surprises. The cash can be distributed to beneficiaries after all income tax liabilities are paid.

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