Consideration needs to be made while determining when to distribute assets out of an estate. Just as an individual pays taxes, so do estates. An estate is required to file an annual income tax return for each calendar year it is open, even if only for part of the year. This is in addition to the estate tax return and the decedent’s final tax return, explains an article “The Dangers Of Distributing Estate Assets Too Soon” from Forbes.
The estate tax return is based on the assets in the estate, the income received and deductible expenses paid during the calendar year. Only one estate tax return is required. However, as long as the estate is open, an annual estate income tax return needs to be filed.
To minimize income, many executors distribute income to beneficiaries shortly after it comes into the estate. The estate takes a deduction for the income distributed to beneficiaries in the same year it is received by the estate. Beneficiaries are required to include the distribution in their gross income.
However, if the estate does not distribute income before the end of the year, the estate will owe income taxes. There are further complexities to be aware of, including what happens if an executor receives unexpected income or does not know the tax impact of certain transactions. The estate has to pay taxes, but what happens if all assets have been distributed?
The estate still owes those taxes. The executor may be personally liable for paying the taxes if they distributed them too early.
In some cases, these kinds of issues can be prevented by maintaining a certain level of cash in the estate account until the final estate tax return is filed. The beneficiaries receive distributions once all of the taxes—estate income, estate and final individual or final joint—are paid.
For larger or more complex estates, it is wise to have a tax discussion with the estate planning attorney, the family CPA and the executor, so all parties are prepared for tax liabilities in advance.
Reference: Forbes (Feb. 16, 2022) “The Dangers Of Distributing Estate Assets Too Soon”