It’s easy to forget that income taxes are an important part of estate planning. But for executors and trustees, managing this tax burden is an essential part of handling the transfer of assets.
One tool that can significantly streamline this process is the Section 645 Election. This section of the tax code allows you to combine an estate and an associated irrevocable trust into a single taxable entity. This reduces the overhead of estate management by letting you file one set of taxes each year rather than two, and by letting you file taxes for both entities on the same schedule.
Here’s how it works.
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Estates and Trusts Each Must File Taxes
In most cases, it takes more than 12 months to wind up an estate and distribute all assets. During this time the estate still must file and pay taxes on any significant income those assets generate.
At the same time, the revocable trust has become an increasingly popular part of estate planning, as it often allows heirs to avoid probate, fees and inheritance disputes. After your death a revocable trust converts to an irrevocable trust, which must also file and pay annual taxes on its underlying assets.
It’s common for decedents to combine these into what is called a “pour-over” approach to estate planning, in which they put major assets into a trust and use their will to distribute residual property. While efficient from a costs and probate standpoint, this creates a two-pronged system in which both aspects of your estate must independently file with the IRS. The estate must file taxes based on its fiscal year, and the trust must file taxes based on the calendar year.
This doubles up the overhead for the executor and trustee, including coordination if your will and your trust are managed by different fiduciaries. In the year of the decedent’s death, it triples the overhead as the executor must also file a 1040 for the individual’s final living months.
A financial advisor can help coordinate your estate to minimize taxes.
How a 645 Election Can Streamline Tax Management
To make this process easier, the IRS allows what is known as a Section 645 Election.
If you hold a revocable trust (often referred to as a living trust) at the time of your death, it will automatically convert into an irrevocable trust once you die. The trust will now be an independently taxed and managed entity.
Once this happens, the executor of your estate and the trustee of the now-irrevocable trust can make a Section 645 Election. This will allow them to treat the irrevocable trust as part of your estate for tax purposes. Your executor can file one set of taxes which will cover all of the assets, income and losses held by both entities. What’s more, your executor can file these taxes based on the estate’s fiscal year.
Using the estate’s fiscal year approach can make time management easier than having to meet the calendar year requirements of the trust. For example, say that a decedent dies at the start of November. By filing a Section 645 Election, the trustee can avoid having to scramble and file taxes for November and December. Instead, the estate can choose a more manageable fiscal year-end, filing its taxes by the following October.
This process also helps reduce some tax requirements and overhead. Most notably, trusts are required to make quarterly estimated tax payments on their assets and income. Estates are not required to do this for the first two years after the decedent’s death, so treating the irrevocable trust as part of the underlying estate can effectively eliminate (or at least suspend) this requirement.
If you need help putting together an estate plan, talk to a financial advisor today.
How to Make a 645 Election
To make a Section 645 Election, the associated trust must by a Qualified Revocable Trust (QRT) as defined by Section 645. This means that the decedent independently owned and controlled the trust at their time of death. Generally speaking, someone is considered to have owned the trust if they had the power to revoke it at any time.
If the trust is a QRT, the executor and the trustee make this election with Form 8855. Both must fill this form out. Once this election is made, the executor must confirm it on the estate’s next tax filing.
Note that one advantage to this election is that estates have a higher exemption than trusts. A trust does not need to file taxes for income less than $100, while an estate does not need to file taxes for income less than $600. However if an estate wishes to make a Section 645 Election then, regardless of income, it must still file its next annual taxes in order to confirm the election.
A Section 645 Election is irrevocable once made, however it is not permanent. It will continue until one of two conditions is met. First, this election ends once one entity distributes all of its assets and winds up. For example, it is not uncommon for a trust to outlast an estate. If the estate is closed but the trust remains open, the election will end. Second, this election ends at the “applicable date.” While this can change under some circumstances, typically the applicable date is set at the later of either two years from the decedent’s death or six months from the final determination of any estate tax liability.
Remember, tax and estate planning can get complicated. If you need help, talk to a financial advisor.
A Section 645 Election is a tax election which allows you to treat an estate and an associated trust as a single entity for the purposes of filing income taxes. This is an irrevocable, but temporary, election which can significantly streamline estate management.
Estate Tax Tips
- Planning for your estate’s taxes can be complicated. Depending on your level of wealth, you should make sure to prepare for the big three: estate taxes, gift taxes and state-level inheritance taxes.
- A financial advisor can help you build a comprehensive retirement plan. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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