Are You Managing A Deceased Estate?
Firstly, good advice can save you a lot of money – so if you are an executor of an estate we highly recommend seeing your accountant as soon as possible.
Secondly, in addition to the above information, we have a great checklist that runs you through most of what you need to do as an executor, including links to ATO forms that need to be completed. You can download that below.
The death of a loved one is a particularly challenging time, and while grieving you are pretty quickly thrown in the deep end. While tax is not the most important or pressing issue you will face, understanding it and attending to it sooner rather than later is important.
Dealing with the tax affairs of a deceased loved one is tricky and complicated. Our Tax Laws don’t make it easy, the ATO doesn’t make it easy, and a general misunderstanding by the general population doesn’t help.
Taxation of a Deceased Estate: The Basics
A deceased estate is technically a special type of trust, and as such Trust Law plays a significant part on whether the estate pays tax on income, or the beneficiaries of the estate pay tax on their share of the income received. One important part of Trust Law is the concept of “Present Entitlement”, as this determines who pays tax on income.
Key Understanding – Present Entitlement
To keep this as simple as possible, when a beneficiary is seen to have an indefeasible interest in assets of the estate, they are seen as “presently entitled” to that asset. This in effect means that there is no real dispute over who is entitled to what. This can’t occur until the administration of the estate has progressed far enough along so that there are no real chances of disputes over the assets, and that all liabilities have been paid or at least provided for.
In general, beneficiaries pay tax on income earned on assets they are presently entitled to, and the estate pays tax on all other income.
Under Tax Law, present entitlement is tested as of 30 June (i.e. the last day of the financial year) – so if a beneficiary is presently entitled to an asset at 30 June, they are liable for tax on all income earned by that asset for the entire income year. We discuss this in more detail later.
Let’s put the above in a little perspective:
Income Earned Up To Date of Death
All income earned by the deceased up to their date of death, needs to be reported on their personal tax return. This return will need to be marked as a “final” return. This is a “normal” tax return, prepared on the same basis of all other tax returns. The deceased is able to access the full year’s tax-free threshold, regardless of when they passed away.
Up To Probate
All income earned after the deceased’s passing and up to probate will be taxable to the estate – this is because until probate is granted, no beneficiaries have any right to any assets, and cannot be seen to be “presently entitled” to any assets.
A deceased estate is taxed in a similar to an individual – the estate is able to access the tax-free threshold, and all other marginal tax rates, which means in effect, a deceased person can access two tax-free thresholds in the year of their passing.
Up To "Fully Administered"
Income earned by the estate (that is not part of an interim distribution) while the estate’s obligations are still being met will be taxable on the estate’s tax return. Again, this is because until all potential challenges are seen off and liabilities are determined, beneficiaries aren’t entitled to any assets.
After "Fully Administered"
Once the estate has no real probability of challenges, all assets have been identified, and all liabilities have been paid or provided for, the estate is “fully administered” and it’s tax treatment changes. Theoretically, at this date the beneficiaries are entitled to be paid their inheritance and can demand that of the estate (i.e. they are presently entitled) – and therefore the income of the estate is taxed the same as any other trust.
Once this point occurs, the beneficiaries pay tax on all future income of the estate, regardless of whether that income was paid to them or not during the financial year.
Distributions of the Estate
How Do Distributions Factor In?
Given “present entitlement” means that a beneficiary has an entitlement to assets of the estate – any time a beneficiary actually receives money (or assets) from the estate, they will be seen as presently entitled to that amount. This is regardless of what “phase” the estate is in (see above).
Present Entitlement at 30 June
One of the quirks of our Tax law is that if you are presently entitled to assets or income as of 30 June (which in effect means at any point during the financial year), then you are personally liable for the tax on the full year’s worth of income.
- For example:
- Lets say a loved one passes on 1 July 20X1 with $500,000 in the bank;
- Probate is granted on 1 October 20X1 and in that 3 months $10,000 of interest has been earned;
- Administration is completed on 31 March 20X2, and in that 6 months another $20,000 of interest has been earned; and
- Final distributions are made shortly after for a total of $530,000.
Going via the “phases” we outlined earlier, all $30,000 of interest was earned before beneficiaries were presently entitled, and therefore should be taxed to the estate – right?
Unfortunately not…
Because beneficiaries were presently entitled to all of the estate as of 30 June 20X2, all income earned in that financial year is taxable to the beneficiaries. This means the estate has $0 taxable income, and the beneficiaries will pay tax on the $30,000 of interest at their personal tax rates.
An ATO Concession
The ATO, in an uncommon gesture of goodwill, accept that this is a little unfair and will allow estates to completely disregard the above and prepare tax returns in a way that better reflects the “phases” we outlined before. Essentially, the ATO say that income earned before the administration of the estate is completed can be taxed in the estate tax return, and income earned after administration is complete (but before distributions are made) is taxed to the beneficiaries.
In order to qualify:
- you need evidence of when income was actually derived during the year – i.e. actual dates income was earned so you can accurately say what income was earned before administration was completed; and
- you or the beneficiaries must request that the income be apportioned in this way.
This is a major win for executors and beneficiaries and can result in major tax savings. If you take our above example ($30,000 of interest being distributed), and assume that this is inherited by an individual earning $100,000:
- If taxed to the estate, the estate will pay $1,888 of tax (first $18,200 tax-free, the balance at 16%);
- If taxed to the beneficiary, they will pay $9,600 of tax (30% plus Medicare Levy).
It is important to note however, that this concession only applies to final distributions.
Interim Distributions
Often, interim distributions are made before all liabilities are ascertained, but the executor has determined that this money is surplus to requirements. A beneficiary is still seen as presently entitled to this money, and will pay tax on income received as part of that distribution.
We note that the “30 June” rule applies in full here (i.e. no ATO concession), and a beneficiary will pay tax on all income earned in that financial year and there is no opportunity to apportion it.
Practically, if an estate earned $50,000 of income in the financial year and the executor distributed 50% of the assets to beneficiaries, then there is potentially tax payable on $25,000 by the beneficiaries.
As a tax planning tip, it is generally advisable that an estate only distributes capital with any interim distributions and clearly documents this. If only the capital of the estate is being distributed and all income is being retained by the estate, then the beneficiaries are not liable for any tax.
Proper documentation is key for this to be effective.
What is Income?
It is key to understand that only “income” is taxable, and the definition of income is unchanged to what you may ordinarily understand it to be.
For example:
- A deceased had a bank account with $500,000 and their residence worth $800,000 upon their passing;
- This is to be split 50/50 with their children;
- The bank account earns $20,000 of interest during the financial year;
- The property was sold, but the sale is tax-free due to it being the main residence of the deceased; and
- The estate was a simple one to administer and was fully finalised all within the one financial year.
In this scenario, each beneficiary will receive:
- 50% of the bank account ($250,000 each);
- 50% of the interest ($10,000 each); and
- 50% of the property sale ($400,000 each).
Only the interest is taxable, and therefore the beneficiaries will only include the $10,000 of interest (each) on their tax returns. This is despite them having received $660,000 each.
Assuming this was a final distribution, the beneficiaries could request that the executor takes advantage of the ATO concession that sees the estate pay tax on this $20,000 of interest.