Let’s imagine, your 90-year-old mother recently passed away, and you’re the executor of her probate assets and the trustee of her trust assets. During this time of emotional hardship, you must also consider the financial responsibilities of your position. You meet with your trusted advisor, and they ask you if you would like to make a Section 645 election, and you think, “What is that?”
A Section 645 election allows the executor or personal representative of an estate and the trustee of a trust to elect to treat the estate and the trust as one for tax purposes. Generally, estates may elect a fiscal year-end or a calendar year-end, whereas trusts default to a calendar year-end. If you elect Section 645, it gives you the ability to place the trust on a fiscal year-end as well, which means only one tax return is required. That sounds great, but why would you want a fiscal year-end?
One reason a fiscal year-end could be beneficial is that it allows the trustee to make additional progress on the estate settlement before a tax return would be due. This tends to be more helpful the later in the year a person passes away.
Consider this example
Let’s say your mother passed away on Oct. 15, 2022. The fiscal year-end would be Sept. 30, 2023; however, the first tax return wouldn’t be due until Jan. 15, 2024. The longer the amount of time between the passing and the tax filing, the greater the chances the estate could be fully administered. This would result in a first and final tax return for the estate.
If you chose to use a calendar year-end in this scenario, however, the first return for your mother’s estate would be due April 15, 2023. Assuming it takes longer than six months to fully administer all assets, a second return would be due for calendar year 2023 on April 15, 2024. While it wouldn’t eliminate any tax due, there is potentially a cost savings on the tax preparation as well as the deferral.
Caution should be used with a fiscal year-end, however, as additional awareness of deadlines and manual tracking is required. Standard tax reporting is all completed on a calendar year-end and is therefore easier to track and administer.
Here are six additional things to consider when evaluating the Section 645 election
1. Mechanics
The election is irrevocable and must be filed on the first Form 1041 trust return. Once you elect the fiscal year on the first filing, you can’t go back to a calendar year-end or separate the trust and estate until the election expires. Additionally, you’re responsible for making sure all filings are timely.
2. Income shifting
As mentioned above, this is the ability to shift income reporting and taxability into a later year. However, the election is only valid for two years, and if the trust isn’t distributed before the election terminates, income distributions would be increased in the final reporting year. This could result in an increase in total tax paid (more on this below). An exception to the two-year election length is when a federal estate tax return (Form 706) is filed. At that point, the election would be the later of two years from the date of death or six months after a closing letter is received from the IRS.
3. Charitable causes
Trusts are generally allowed a charitable deduction only for amounts given to charities in the current or following year. However, estates are allowed a charitable deduction for amounts permanently set aside for charitable purposes. So, you can set aside income and get a deduction but not actually distribute any funds until a later date.
4. Exemptions
Trusts are allowed a personal exemption of either $100 or $300, depending on whether or not all the income from the trust is required to be paid out. Estates, however, are allowed a $600 exemption. While both are relatively low, electing Section 645 will allow the trust to utilize the $600 exemption.
5. Estimated tax payments
Estates are exempt from making estimated tax payments for two years following the date of passing. Trusts may need to make estimated payments depending on the situation. It should be noted, it’s possible for a trust to qualify for a two-year exemption from making estimated payments without electing, but these provisions are very narrow.
6. S corporation stock
An estate is allowed to own S corporations stock for a longer period of time than a trust. Trusts can hold the stock only for the two-year period beginning at the date of death. Estates can hold the stock through the period of administration. This could be an advantage for trusts that own S corporation stock.
So, what happens at the end of the election period? At the end of the election period or upon the distribution of assets from the original trust to a new trust, the new trust will return to calendar year-end filings. As such, the trust would need to file a return from the end of the fiscal year-end to the calendar year-end following the termination. This may lead to the beneficiaries receiving two K-1s forms for reporting on their individual income tax returns. Therefore, they would have increased income to report on their personal returns. While this might not be detrimental to all, it could push other beneficiaries into a higher tax bracket. If that were true, it could cost the beneficiaries more in the end than the deferral of the tax in the first year. This consideration is often missed. However, if they are already in the highest tax bracket or reporting the additional income will not move them from their current bracket, the deferral could be advantageous.
As you can see, there are several factors to consider when looking at tax strategies after a loved one passes away. Contact us to learn more about Plante Moran’s holistic approach to these decisions.
