Obtain a federal tax ID number

Before you get started on any tax return, you need to know the federal Taxpayer Identification Number (or TIN), which will be either an Employer Identification Number (EIN) for estate and trust returns or the decedent’s Social Security number (SSN) for his or her final Form 1040.

Finding the decedent’s SSN is easy; it’s scattered all over his or her financial documents. The EIN, however, doesn’t exist until you apply for it. We advise applying for one as soon as you know you’re (a) going to have to open an estate bank account or investment account or (b) you’re going to have to file any sort of tax return for the estate (either income or estate). Apply for the estate or trust’s TIN by using Form SS-4, Application for Employer Identification Number, which you can get by visiting any IRS office, phoning 800-829-4933, or going to www.irs.gov (just click on “I need to apply for an EIN” to go directly to the form). When applying by phone or online, you receive your number immediately; you’ll receive a response to an application to the IRS service center for your state within four business days. If you file a physical application by mail, it takes up to ten days to receive the form from the IRS, and up to an additional four weeks to receive the number itself.

Every taxpayer needs a TIN, and you’re not allowed to file any tax returns without one that has been specifically assigned to that person, trust or estate. You can’t use the decedent’s SSN to file an estate return, nor can you use the estate’s EIN to file a return for a trust that inherits the estate’s property. Still, obtaining a TIN only costs you a little time and no money, so don’t feel like you’re being wasteful because you’re not able to recycle ones that are no longer useful, like the decedent’s SSN. Be careful, though, and only apply for a TIN once for each taxpayer. Nothing is worse than trying to sort out the confusion with the IRS and your banks, brokerages, and anyone else to whom you’ve given the information, when an estate or trust has more than one EIN.

If you need to open even one bank or brokerage account for an estate, you have to apply for a TIN to do so. Applying alerts the IRS that a new trust or estate exists; it’s going to expect tax returns from that entity, even if there’s no obligation to file one. Not to worry — if you receive a notice asking for a tax return, send the IRS a letter explaining that the estate didn’t have enough income to file. Or, to avoid the notice altogether, you can prepare and file a return showing no income.

If you need multiple EINs because you have multiple entities, take note: The days of applying for the estate’s EIN on the same day as you apply for the follow-up trust’s EIN are officially over. A new administrative rule limits the number of EINs you may apply for to one per day, no matter what method you use to apply (e-mail, fax, phone, or snail mail).

Choose a tax year-end

Although Congress created a general rule in 1986 that all individuals, businesses, and most trusts had to use December 31 as their tax year-end, every rule has exceptions. An estate may choose the last day of any month as its tax year-end, provided the first year doesn’t include more than 12 months.

Why choose a date other than December 31 as a tax year-end? Depending on how much income the estate stands to receive (and when), using a different year-end can substantially reduce the total income tax bite, especially if the estate’s administration will take more than 12 months from start to finish. If you haven’t already, create a schedule of when and how much income you expect the estate to receive.

Because estates and trusts reach the highest tax bracket very quickly, we recommend you split the initial flow of income into two years, if possible. Whether the estate is paying the tax, or distributions to the beneficiaries mean that they’ll be responsible for the income tax bill, splitting income into two years can ease the overall income tax burden for both the estate and the heirs.

You’ll be asked to declare a year-end when applying for the trust or estate’s EIN, but your decision isn’t absolutely final until you file that first income tax return and put the year-end on the top of page 1. For example, the decedent died on April 15, and you initially chose a December 31 year-end because you didn’t know that you could choose differently. The estate paid large, tax-deductible expenses before December 31, but ended up receiving the majority of its income in January and March of the following year. If the tax year-end remains December 31, the first tax return has no tax due and misses out on large deductions (because it has no income to offset them), while the second year’s return will show lots of income, few deductions, and a large tax bill. By changing the year-end to January 31 (which is still less than twelve months after the decedent died), you can move some income back into the estate’s first tax year — hopefully enough to offset the deductions — and drastically reduce the amount of taxable income in the second tax year. You’ve reduced not only the income tax due on that return but also the total amount of income taxes paid by the estate over the course of administration.

If you choose a year-end other than December 31, you’re responsible for correctly accounting for all income received because the 1099s you receive from banks, brokerages, and others may not accurately reflect income for the tax year. Only your good recordkeeping will produce an accurate tax return.

Interest

Interest is income you receive because you’ve lent money. No matter where or to whom you lend money — to banks, the U.S. Treasury, state and local governments (municipal bonds), corporations, foreign governments, or your nephew Fred — the income earned from that investment is interest.

With the exception of interest you earn when making personal loans, Form 1099-INT should tell you how much interest you’re dealing with. Just add up all the Form 1099-INTs to get this year’s total. For non-calendar-year filers, remember that using 1099 information may cause you to either over- or under-report income. Make sure that you keep excellent records to make up for this discrepancy. You report total taxable interest on line 1 of Form 1041, or line 8a of Form 1040. You show exempt interest (interest not subject to federal income tax, like interest from municipal bonds) on the back of Form 1041, on Question 1 of “Other Information”; if you’re preparing the decedent’s final 1040, place his or her exempt interest on line 8b.

Dividends

Unlike interest, dividends represent profits from a company in which you own shares. You can earn dividends from publicly traded or closely held corporations and from U.S. or foreign companies. You may receive them from specific corporations or from shares owned in a mutual fund, which buys and sells the shares of many corporations, giving you tiny pieces of each individual dividend. Regardless of the source, every January you receive a Form 1099-DIV, showing how much you earned from dividends.

The most common types of dividend payments shown on Form 1099-DIV are the following:

• Total dividends: Total dividends are the total amount of ordinary dividends you received. Add these numbers up from all your Forms 1099-DIVs and place the total on line 2a of Form 1041 or line 9a of Form 1040.
• Qualified dividends: As a portion of the total dividend, qualified dividends reported in box 1b of Form 1099-DIV are subject to lower income tax rates. If you received more than one Form 1099-DIV and each has an amount listed in box 1b, add all amounts shown in box 1b and either place the total on line 9b of Form 1040 or split the total between lines 2b(1) and 2b(2) of Form 1041. Chapter 20 tells you how to make the allocation between the two lines.
• Capital gain dividends: Capital gain dividends are payments you received, primarily from mutual funds, that derive from the sale of assets within the fund and that are subject to a lower income tax rate. You typically place the amounts shown in box 2 of Form 1099-DIV on Schedule D (for either a Form 1040 or a Form 1041). However, if you’re preparing the decedent’s Form 1040 and he or she had no other capital gains or losses, check the box next to line 13 of Form 1040 and then fill in the amount.

Business income

Business income is income received from operating a business, one that the taxpayer owns either wholly or only in part, like a shareholder in a Subchapter S corporation. If the decedent operated a business as a sole proprietor (meaning that he or she was the owner of the company and declared his or her business income on Schedule C of Form 1040; check out Chapter 7 for more info), you probably have to prepare a Schedule C to file with both the final Form 1040 and with the estate’s Form 1041, at least while you’re wrapping up the affairs of the business. After you complete Schedule C, place the total on line 3 of Form 1041 or line 12 of Form 1040. If income is received from a Subchapter S corporation or a partnership, you receive a Schedule K-1 from that entity’s income tax return, reporting all the types of income you need to include on either the decedent’s Form 1040 or the trust or estate’s Form 1041; only include on the business income lines of these tax returns amounts labeled as ordinary income on Schedule K-1.

Although paying self-employment tax after a person dies may sound strange, income earned from a sole proprietorship declared on Form 1040 is still subject to that additional tax. Don’t forget to prepare and include Schedule SE with the decedent’s final Form 1040. After the business is operating under the estate’s ownership, self-employment tax disappears. Evidently, someone got the memo that the estate would never collect Social Security or Medicare.

Capital gains and losses

We know you love definitions, so here are a few useful ones to help you calculate the capital gains and losses. Capital property is anything that is owned by an entity that is used to generate income, income that may be earned either during the course of ownership or when the property is sold. A capital gain is the profit earned when a piece of capital property is sold for more than its acquisition cost (otherwise known as basis), whereas a capital loss recognizes the difference between a low sales price and its higher basis. Although there’s a difference between property held for personal use and capital property in an individual’s life (which is why you don’t need to report the gains and losses you receive from your annual yard sale), trusts and estates don’t use hairdryers and tableware, so all property owned by a trust or estate is capital property, and all gains and losses realized on their sale must be accounted for on Form 8949, Sales and Other Dispositions of Capital Assets, with the totals carrying forward to Schedule D of Form 1041.

Whenever you sell property, the difference between your basis in the property and the sale price determines the capital gain or loss. In order to figure out what number to use on line 4 of Form 1041 or line 13 of Form 1040, you need to know not only these numbers but also the acquisition dates and sale dates of all property sold. Don’t worry, though. Proceeds from sales and sale dates are easy to sort out because you receive Form 1099-B for the sale of all securities and Form 1099-S for the sale of a house.

However, figuring out what acquisition costs and dates and numbers to use can sometimes be confusing. And if that’s not bad enough, you also have to calculate the holding period — the length of time the entity’s owned the property. Here, you have a choice among the following:

• Long-term gain or loss (property owned for more than one year)
• Short-term gain or loss (property owned for one year or less)
• Inherited property, which automatically is treated as long-term, even if the estate or trust has only owned it for a day or less

Table 18-1 shows which acquisition costs to use. Note: Alternate valuation is determined six months after date of death and must be elected on the decedent’s Form 706; see Chapter 16 for further details.

Just because the decedent’s estate isn’t large enough to warrant filing a Form 706 doesn’t mean that the value of his or her property doesn’t benefit from the so-called step-up or increase in basis. Unless the decedent died in 2010, the basis of the property the decedent owned at death changes to the date of death value, and the new acquisition date is the decedent’s date of death. For example, John Smith owns XYZ Corp stock he purchased for $50 per share in 2003. At his death in 2013, the stock was worth $100 per share. Even though Mr. Smith doesn’t have a taxable estate, the acquisition cost for his XYZ Corp shares is now $100 per share. When his executor sells the shares for $100 each, no gain or loss is recognized because the sales price equals the stepped-up acquisition cost, so no capital gains tax is due on the sale.

As part of the provisions of the Emergency Economic Stabilization Act of 2008, the decedent’s broker is now required to report acquisition costs for stocks and bonds purchased or otherwise acquired after January 1, 2011, and for mutual fund shares purchased or otherwise acquired after January 1, 2012. Beware: Just because the broker gives you the cost doesn’t mean it’s accurate. He or she may not have revalued all the assets as of the decedent’s date of death prior to issuing Form 1099-B, Proceeds from broker and barter exchange transactions. If you know the basis information is incorrect, you may make the necessary adjustments on Form 8949, Sales and Other Dispositions of Capital Assets, in boxes (f) and (g).

Income from rents, royalties, partnerships, and other estates and trusts

If the decedent, estate, or trust owned rental property, had an interest in any mining activities, published any works (or had an interest in published works), was a member of a partnership, or was a beneficiary of another estate or trust, you’re going to have to fill out Schedule E, Supplemental Income and Loss. The good news: Whether you’re preparing Form 1040 or Form 1041, Schedule E is the same.

• Part 1 of Schedule E covers the income and/or loss from rental and royalty income.
• Part 2 gives you space to show the same information from Partnerships and S corporations.
• Part 3 wants to know about any income from other estates or trusts that you may have to report on this return.

In addition to being the collection point for information on all these types of income, Schedule E is also the spot where you need to decide whether the income you received is active or passive. Basically, you need to determine whether the participant actively participated in the business or was merely an investor (someone not involved in the day-to-day activities of that business). If you’re preparing a Form 1041, the answer to this question is fairly simple — trusts and estates are rarely active participants in partnerships and S corporations, and rental and royalty income is, by definition, passive, so the income and/or losses from these activities are almost always passive. If you’re filing a 1040 return for the decedent, the distinction isn’t always so clear-cut and rests on the level of decision-making and management control exercised by the decedent.

Whether you’re filing a Form 1040 or Form 1041, if you have passive losses you may deduct them only against passive income; passive losses that exceed passive income are suspended. Calculate your passive loss limitations on Form 8582, Passive Activity Loss Limitations.

Farm income or loss

If the decedent owned a farm, the land doesn’t just disappear because he or she has died. The farm will continue operations, at least until you can find someone to buy or lease the property, and you’ll need to report any income or loss from it. Before you can fill in a number on line 6 of Form 1041 or line 18 of Form 1040, you’re going to have to wend your way through Schedule F. Fortunately, Form 1041 doesn’t have a separate Schedule F, so after you figure out how to prepare one, you can easily transfer those skills from the decedent’s Form 1040 to the estate or trust’s Form 1041.

Ordinary gain or loss

If your decedent owned any sort of business property (from real estate owned as part of a business to office equipment, cars, or any other property that had a business use), when you sell it you’re going to report that sale on Form 4797, Sale of Business Property. Use Part 1 to report sales of property held long term by the decedent, trust, or estate and Part 2 for short-term sales. Note: Property that an estate or trust acquires due to the decedent’s death constitutes an inheritance, uses the date-of-death value for its acquisition cost and date of death for its acquisition date, and qualifies as a long-term holding, even if the sale occurs the day after the decedent died.

Like Form 8949, Form 4797 needs a description of the property sold, acquisition and sale dates, and the taxpayer’s cost of acquisition. (Refer to Table 18-1 for help determining the acquisition date and basis cost for property.) In addition to this information, if the property depreciated over time (where the property’s value is recovered over its useful economic life), you must add the total amount of depreciation to the sale price in order to calculate the gain or loss. Look at the decedent’s prior years’ income tax return to see what property he or she was depreciating. If there’s no sole proprietorship (Schedule C), rental property (Schedule E), or farm (Schedule F), you’re off the hook in regard to depreciable property. If any of those schedules are attached to a prior return, you may want to consult a tax expert for assistance in determining how much, if any, of the depreciation taken must be recaptured. If that sounds something like caging a wild animal, well, you’re not too far off the mark.

After you complete Form 4797, carry the short-term gains or losses from line 17 of Form 4797 to Form 1041, line 7. If you’re filing the decedent’s Form 1040, follow the instructions for lines 18a and b. Some of your losses may end up on Schedule A, Itemized Deductions; gains and other losses not reported on Schedule A end up on Form 1040, line 14. Long-term gains or losses take a detour through Schedule D (1041, line 10 or 1040, line 11) so that you can factor these long-term sales into your tax calculations.

On Form 4797, you also report casualty losses (which are losses from a theft, or a disaster, such as a fire, flood, or earthquake), and the gain or loss received on installment sales (where you receive the proceeds from the sale over a period of years, not all at once) and on like-kind exchanges (where you exchange one piece of property for another, similar piece of property). Casualty losses, installment sales, and like-kind exchanges are very technical transactions, and you may want to consult an attorney, an accountant, or an Enrolled Agent before either entering into one or attempting to report the one you’ve already participated in to the IRS.

Other income

You’ve already figured out that you need to declare all income whether it falls into any of the categories described in the previous seven sections or not, and you need to pay any income taxes owed on it. Line 8 of Form 1041 (or line 21 of Form 1041) is where you put those items that defy description, the ones that you can’t possibly squeeze into any of the categories already listed. Although on Form 1040, popular “other income” items include fees and honoraria and jury duty pay, on Form 1041, the most common item will be taxable state income tax refunds. If the trust or estate is a party to a lawsuit (either its own, or as a successor to the decedent), place any taxable awards received here.

Interest

Whether you’re responsible for filing a Form 1040 or a Form 1041, the following types of interest are deductible:

• Interest paid on a mortgage that’s secured by real estate (including interest on home equity lines of credit)
• Interest that you pay for a stock margin account

Personal interest paid on such things as credit card debts, unsecured loans, or unpaid tax bills is never deductible.

But wait! This rule has an exception, too. If you elect to pay the estate tax under Section 6166 (that’s an election to spread out the payment of the estate taxes owed over a ten-year period), you get to deduct that interest on Form 1041, even though it’s interest on an unpaid tax bill. Why? Even though it’s so-called personal interest, it’s also an interest payment that arises only because you’re dealing with an estate (or a successor-in-interest trust, which receives the assets of the estate after estate administration is complete). You can deduct expenses the estate or trust incurs for being an estate or trust; the fact that only an estate or trust can pay Section 6166 interest overrides the rule that personal interest is nondeductible.

Taxes

Generally speaking, taxes in a trust or estate refer to real estate taxes and state and local income taxes. Although individuals also have the option of deducting state and local sales taxes rather than income taxes, that option doesn’t exist in the estate/trust environment. We think the IRS has figured out that estates and trusts aren’t out there buying consumer goods, but that’s only a guess on our part.

Just as you get to do on Schedule A, you can deduct the actual amounts you paid as taxes during the estate or trust’s tax year on line 11 of Form 1041. Remember: You get the deduction only for amounts you actually paid, so don’t include estimated taxes you paid in the first month of the following tax year. However, pick up your fourth quarter estimated tax payment from the prior tax year if you paid it in the current year. Also, if you applied an overpayment from last year’s return to this year’s, pick up the overpayment not only as income (if you deducted it in the prior year) on line 8 of Form 1041 but also as a deduction on line 11.

Fiduciary fees

If you’re doing all this work out of the goodness of your heart, you can skip right over line 12 of Form 1041. But if you’ve figured out that the amount of work involved in administering this trust or estate is so much that you really need to be paid, line 12 is where you deduct your fiduciary fees.

Fiduciary fees (the amounts executors, administrators, or trustees charge for their services) are generally fully deductible. But if some portion of the income for the estate or trust comes from municipal bonds or other tax-exempt vehicles (tax-exempt money market funds, for example), you’re required to allocate fiduciary fees between taxable and tax-exempt income, and you get to deduct only the amount allocable to taxable income. To calculate the allocation, subtotal the income shown on lines 1 through 8 of Form 1041 and add the tax-exempt income from line 1 in “Other Information” on the back of the return to arrive at total income. Divide the total income by the total taxable income and multiply the results by the total fiduciary fees. You take the deductible fees on line 12 and subtract the balance from the total tax-exempt income to arrive at the adjusted tax-exempt income. Place that number on Schedule B, line 2.

For estates, you probably want to base the executor’s fee you charge on the number of hours you actually work on estate matters. Set a rate that you feel your time is worth, and keep careful track of your time. (See Chapter 9 for a further discussion of how to arrive at an executor’s fee.) For trusts, if you’re making the investment decisions, you may want to obtain a fee schedule from a trust company, which charges its trust clients a percentage of the market value of the assets it holds, plus a percentage of income collected, as its fee. Your fee shouldn’t exceed that of a bank or trust company, and it probably will be less because your overhead is much less. If you’re paying an outside advisor for investment advice, you’ll most likely want to subtract his fee from the one the bank or trust company charges; after all, investment advice is already included in the fee he charges.

Charitable deductions

The rule concerning charitable deductions is fairly straightforward. You can’t give away money from an estate or trust to charity, no matter how good the cause, unless the decedent’s will (or the trust instrument) tells you to. Because this rule is absolute, you don’t often see charitable deductions on an estate or trust income tax return. You’re not even allowed to take a deduction for the contents of the house or the decedent’s clothes that you gave away to Goodwill unless the decedent directed you to do that under his or her will.

If the terms of the decedent’s will direct that you give a percentage of the estate (or, for particularly generous decedents, the whole shebang) to charity, you calculate the charitable deduction on Schedule A, located on the back of Form 1041. Other times, charitable deductions can occur when the trust or estate owns a partnership or S corporation interest and that entity gave to charity. Because the decision to give wasn’t yours, you may take the deduction.

Frequently, donors establish trusts with either whole or partial charitable interests and fund them either by gifts made before death or from their estates after death. These trusts may either be set up as private foundations, or as charitable lead (or remainder) annuity trusts, or unitrusts. In most cases, these trusts don’t file a Form 1041, and the returns they do file (Forms 5227 or 990-PF) aren’t for the faint of heart. If you’re named as trustee for one of these types of trusts, get an attorney, accountant, or Enrolled Agent experienced with these returns who can assist you in tax preparation. Strangely enough, most tax professionals don’t prepare these sorts of returns, so make sure that you find someone who has the expertise you need. Check out Chapter 3 for a description of each of these types of trusts.

Attorney, accountant, and preparer fees

Although Schedule A of Form 1040 limits deductibility for attorney, accountant, and return-preparer fees, Form 1041 allows you to fully deduct these fees (which are miscellaneous itemized deductions limited to amounts more than 2 percent of adjusted gross income). If you have tax exempt income on question 1 of the “Other Information” section on the back of the 1041, you have to split the fees between taxable and tax-exempt income, and are only allowed to deduct the portion attributable to the taxable income. For details on how to allocate between taxable and tax-exempt income, check out the earlier “Fiduciary fees” section. After you add your fees and allocate when necessary, place your deduction on line 14 of Form 1041.

Miscellaneous itemized deductions

If you’ve run out of specific categories but still have some things you suspect you can deduct, lines 15a and 15b of Form 1041 are where you need to be. Just like Schedule A of Form 1040, some of these miscellaneous itemized deductions (which include fees for investment advice, security fees that your broker may charge you, or safe deposit box fees) are subject to the so-called 2 percent haircut (you can only deduct amounts that are greater than 2 percent of adjusted gross income); others aren’t, such as the amount you spend on postage and making photocopies.

The general rule is that expenses that are incurred only because this is an estate or trust are fully deductible, whereas fees that anyone in the position of looking after investments would pay are subject to the 2 percent exclusion. The following sections outline the miscellaneous itemized deductions you can make.

The Income Distribution Deduction (Schedule B)

Unique to the world of trusts and estates is the concept of the Income Distribution Deduction (Schedule B). When trusts and estates pass out payments of income to beneficiaries (as opposed to payments of specific property called for under the will or the trust instrument), those payments carry income tax consequences for the trust or estate and for the beneficiaries. The trust or estate receives a deduction, and the beneficiaries must include the amount deducted from the Form 1041 on their individual Form 1040. Form 1041, Schedule B, synthesizes all the info you’ve compiled to this point into the all-important income distribution deduction.

Although Schedule B may look intimidating, it’s really not so bad. Just follow these steps (unless the trust or estate is in its final year):

1. Take the total from line 17 on the front of Form 1041 (line 1).
2. Add that total to the adjusted tax-exempt interest, which is nothing more than total tax-exempt interest less fiduciary and other fees allocated to it (also known as the contents of line 2).
3. Enter the net capital gain (flip your tax return to its front, and place the number you see on line 4 onto Schedule B, line 6, on the back).

4. Subtract that number from your total of Schedule B, lines 1 and 2, to arrive at the distributable net income (DNI).

   DNI is the total amount that could possibly be taxed to the beneficiary if the world were perfectly round and all the planets were aligned.

If you’re preparing the return for an estate or simple trust, you can ignore Schedule B, line 8. If yours is a complex trust, though, and you’re either not required to distribute all income or you distributed more than just income, you need to calculate trust accounting income (TAI). To calculate TAI, add lines 1 through 8 from the front of Form 1041 and the tax-exempt income from line 1 of “Other Information” on the back of Form 1041. Subtract capital gains or losses (line 4, Form 1041) and all fees and expenses that you charged against the income earned in the trust. Exclude fees and expenses charged against principal (including whatever fees you paid from the capital gains) when calculating TAI, and don’t allocate any of the income fees you paid between taxable and tax-exempt income.

On Schedule B, line 11, put down the total amount of distributions made from the estate or trust to beneficiaries during the tax year. These amounts may be mandatory, such as in the case of a simple trust, where all income must be distributed in the tax year that you’re preparing the return for. In this case, one of three scenarios may apply:

• If you’re required to distribute all, or any part, of the trust’s income with no exceptions, place the amount you’re required to pay to the beneficiary (even if you didn’t actually pay it) on line 9.
• Any amounts of income you paid to the beneficiary at your discretion, but that weren’t mandated by the trust instrument, belong on line 10.
• Add lines 9 and 10 and place the total on line 11.

On line 12, calculate what portion of that total distribution came from tax-exempt income. If you distributed 100 percent of the income, place the number you have on Schedule B, line 2. If you distributed less than 100 percent, calculate the percentage of income you did distribute and then multiply that percentage by the amount on Schedule B, line 2. Subtract line 12 from line 11 to arrive at line 13.

The income distribution deduction is an either/or calculation, and now that you’ve calculated either (line 13), you need to also arrive at or (line 14). This part is much easier — just subtract line 2 of Schedule B from line 7 and place your answer on line 14. Compare lines 13 and 14. The smaller of the two is the income distribution deduction. Place your answer on line 15 of Schedule B and then carry the result to line 18 on page 1 of Form 1041.

The estate tax deduction

Very often, an estate has, as an asset, the right to receive items of income on which income tax has yet to be paid. If the estate is large enough to pay an estate tax, those income items (called Income in Respect of Decedent or IRD) are taxed twice — once on the transfer of property (estate tax) and again on the receipt of income (income tax). Of course, this double taxation on the part of Congress is grossly unfair and expensive and completely uncalled for. Congress, to its credit, has recognized this problem and instituted the estate tax deduction.

The types of IRD that most commonly trigger the estate tax deduction are pensions and IRAs, final wages, and the sale of property (either due to an ongoing installment sale or because the decedent dies after the purchase and sale agreement is signed, but prior to the actual property transfer).

If you’re administering a large estate and have paid an estate tax, you may be entitled to a deduction on the estate or trust’s income tax return (on Form 1041, line 19) for the portion of estate taxes paid on these IRD items. You determine this deduction by calculating the estate tax based on the value of the total estate, including IRD, and then calculating it a second time on the value without IRD. The difference in the two calculations is the amount of estate tax paid on that piece of income; this is the amount of your deduction. Chapter 16 walks you through the estate tax calculation. After you’ve done it twice (once with IRD, and once without), you’ll be a pro at it.

Taxes owed

No matter which tax return you’re preparing (the decedent’s personal return or one for an estate or trust), you have to calculate the tax after you figure out the income and the deductions. If you’re working on the decedent’s return, you arrive at your tax liability exactly the same way as you would your own. If you’re finishing up a Form 1041 and need to figure out Schedule G (on the back), read on. The following is a list of the different types of tax computations you may need to perform before you can put the finishing touches on the tax return you’re preparing.

Credits

After you put the sum of lines 1a through 1c on Schedule G, line d, you’re ready to see whether you can reduce your tax with tax credits. Tax credits are dollar-for-dollar amounts that you subtract from your tax liability; they’re much better than deductions. Estates and trusts aren’t eligible for most of the tax credits individuals can take, and no credit on Form 1041 can reduce the tax liability below zero.

However, on lines 2a through 2d of Schedule G, you have the opportunity to reduce the trust or estate’s tax liability with the following credits:

• Foreign tax credit: You’re entitled to take a credit for taxes you’ve paid to a foreign country with whom the United States has a tax treaty (which is almost everywhere, with a few exceptions such as Iraq, Iran, and North Korea). If the amount of foreign taxes paid is $300 or less, you can just fill in the amount actually paid on line 2a. However, if the amount is greater than $300, you have to become acquainted with Form 1116, Foreign Tax Credit. The IRS understands that this form is evil (which is why they allow you to skip it for relatively small amounts), and it estimates that it should take you about seven hours to complete. If you made income distributions to beneficiaries during the year, you should allocate the applicable portion of the foreign tax credit to the beneficiary as his or her percentage share of the total income.

  Form 1116 has been known to bring even the most brilliant accountants to their knees. If you need to attach one of these forms to your return, especially if you have large amounts of qualified dividends or long-term capital gains, you may want to consult a professional here.

• General business credits: Enter the total of all the general business credits the trust or estate is entitled to on Form 3800, General Business Credit, on line 2c of Schedule G. If you made income distributions during the year, be careful not to include any credits on Form 1041 that are allocable to the income beneficiary.
• Credit for prior year minimum tax: If the trust or estate paid AMT in a prior year, it may be eligible to reclaim some part of that tax on Schedule G, line 2d. Complete Form 8801, Credit for Prior Year Minimum Tax – Individuals, Estates and Trusts to see whether this return qualifies.
• Credit to holders of tax credit bonds: Certain types of loans for items such as clean, renewable energy; Midwestern tax credits; forestry conservation bonds; energy conservation bonds; school construction bonds; and the always-popular Build America Bond allow the taxpayer to take a credit instead of receiving all, or a portion, of the interest that would be earned on that loan. Not all bonds qualify, but your broker will know and should label these securities as such. You should receive Form 1099-BTC, Bond Tax Credit, reporting these credits to you. Complete Form 8912, Credit to Holders of Tax Credit Bonds, and enter the amount on line 12 on Form 1041, Schedule G, line 2d.

Additional taxes

Even if you manage to reduce the estate, trust, or decedent’s income tax liability to zero with a combination of deductions and credits, you may still have taxes to pay. Lines 5 and 6 of Schedule G, Form 1041, are where you find these additional taxes. They’re not really income taxes, but they’re here on an income tax form for lack of any better place to put them.

• Recapture taxes: Sometimes you receive a credit in a prior year, and then in the current year, you find you’re no longer eligible for it. For example, say you received a small business credit last year, and then discovered this year that the payments you made to qualify for that tax were later refunded. Welcome to the world of recapture taxes, which recapture tax benefits that the IRS doesn’t want to let slip away. Complete Form 4255, Recapture of Investment Credit or Form 8611, Recapture of Low-Income Housing Credit, and then fill in the total on line 5, Schedule G.

  Recapture taxes are a fairly technical area. If you suspect you may be subject to them, you may want to check in with a qualified tax advisor for assistance.

• Household employee taxes: When a trust pays for household help for a beneficiary, or an estate pays the final wages of the decedent’s household help, you may have to complete and file Schedule H (Form 1040), Household Employment Taxes. Put the total household taxes calculated on Form 1041, Schedule G, line 6.