Tax Attributes Prove to be a Valuable Tool in Post-Mortem Income Tax Planning for Decedents and Survivors by Jeffrey M. Mutnik, CPA/PFS
Posted on August 21, 2018 by Jeffrey Mutnik
Under U.S. tax laws, the losses, credits and adjustments that a taxpayer is entitled to claim on his or her tax returns are unique to that specific individual, regardless of whether or not he or she is married and/or annually files joint tax returns with his or her spouse. Therefore, the tax attributes that an individual may use to reduce gross income and federal tax liabilities will not automatically transfer to a surviving spouse or the beneficiary of a decedent’s estate. One example of this concerns business losses.
The services that a business owner performs on a daily basis ultimately influence the overall success and profitability of that company. If the owner is unable to work due to illness, injury or death, it is likely that the business will suffer and generate losses. When businesses are structured as sole proprietorships or pass-through entities, such as partnerships or S Corporations, the owners, or partners, will report these losses on their federal tax returns.
When a business’s losses exceeded taxpayers’ income in 2017 or prior, taxpayers created Net Operating Losses (NOLs) that they could carry backwards to claim refunds on taxes already paid during the two preceding tax years. If a taxpayer died in the year of the NOL, he or she was able to transfer the carryback refunds to his or her estate. This is no longer the case, as the Tax Cuts and Jobs Act that went into effect in 2018 eliminates NOL carrybacks.
While the new tax laws do preserve taxpayers’ ability to carry forward NOLs to offset income in future years, this benefit does not typically apply to taxpayers who pass away in 2018 or later, as they will not file any additional tax returns in the years following their deaths. Moreover, because those losses are unique to the deceased taxpayer, they are not transferrable to the decedent’s estate or to his or her surviving spouse to use in the future. However, all is not lost. In fact, there are a few opportunities for taxpayers to absorb some or all of their spouses’ NOLs in the year of their spouses’ deaths, which could essentially create tax-free income for their heirs.
To take advantage of such losses, a surviving spouse should choose to file federal income tax returns as “married filing jointly” for the year in which his or her spouse passes away. Doing so will allow the survivor to use the decedent’s unused NOL (either from current or prior years) to offset the couple’s combined reportable income for the year. After December 31 in the year of the decedent’s death, however, those losses will disappear and no longer be available to the decedent’s heirs. Therefore, it behooves a surviving spouse to meet with tax advisors as soon as possible after the death of a husband or wife in order to project taxable income for the year and analyze the efficacy of recognizing income by year-end.
One way that a surviving spouse may make use of the NOL of a late husband or wife is to create income by withdrawing money from a retirement account. If the surviving spouse does not need the cash from a retirement plan distribution, he or she can roll over the distribution into a Roth account. It even makes sense for a surviving spouse to take a retirement plan distribution that exceeds the amount of the decedent’s NOL for three reasons:
- The NOL will eliminate the surviving spouse’s tax liability on the bulk of the income generated by the distribution, leaving the remaining amount subject to tax at the lowest level(s) of the graduated tax rates;
- An individual can avoid tax on a voluntary retirement plan withdrawal that is not a required minimum distribution (RMD) when they return the withdrawn amount to his or her retirement account within 60 days; and
- Withdrawing cash from a retirement account will lower the asset base of the survivor’s deferred income, thereby lowering the amount of future RMDs.
Another way that individuals may use deceased spouses’ NOLs is to create income in the year that their husbands or wives pass away by selling appreciated assets that the decedents did not own. The NOL would essentially eliminate the taxable gain that such a sale typically would trigger. Nonetheless, it is important for survivors to know that the wash-sale rules do not apply to assets sold for a gain. As a result, they can repurchase the sold asset(s) immediately and receive the benefit of new, stepped-up tax basis.
As a final option, taxpayers may rely on the tried-and-true methods of accelerating income and/or deferring deductions to absorb a decedent’s loss that would otherwise go unused.
It is common for individuals to overlook the importance of tax attributes during a chaotic year in which a loved one passes away. Working with advisors who have the knowledge and experience in these matters can yield significant tax benefits.
About the Author: Jeffrey M. Mutnik, CPA/PFS, is a director of Taxation and Financial Services with Berkowitz Pollack Brant Advisors and Accountants, where he provides tax- and estate-planning counsel to high-net-worth families, closely held businesses and professional services firms. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at firstname.lastname@example.org.