When a decedent leaves assets in an estate and those assets generate income, that income is subject to federal income tax. For example, investments that are in the estate may generate interest, dividends and capital gains. This income from the estate is taxable to either the estate or to its beneficiaries.
It should be noted that the tax return for the income from an estate is different from the estate tax return, which must be filed for estates with a value over a certain amount, in which the tax is based on the total value of the estate assets. A tax return may have to be filed for the income generated by the assets in the estate even if an estate tax return does not have to be filed.
Generally a Form 1041 would have to be filed for the estate if the gross income from the estate for the year is $600 or more. If the income from assets in the estate is less than $600, or if all the income-producing assets such as property with right of survivorship, or accounts with a designated beneficiary pass directly to the beneficiaries, it would not be necessary to file a Form 1041.
If income-producing assets remain in the estate and the income from the estate is distributed to the beneficiaries, the estate would claim a deduction on Form 1041 for the distributed income. A Schedule K-1 would be filed to inform the beneficiaries of the distributed income. The beneficiaries would then include this income on their personal tax returns.
As pointed out by the IRS, some income must be distributed currently from the estate according to local law or according to the terms of the will. The estate executor or administrator may have more discretion in distributing other income from the estate to the beneficiaries.
As indicated by Sonja Pippen, Ph.D. in an article for the Journal of Accountancy, income from estates may be subject to tax at higher rates than those that apply to individuals. For example, the income tax rates on an estate reach the maximum rate at a much lower level of income ($11,650 for 2012) than they do for individuals.
And the 3.8% Medicare tax on investment income applies on a lower threshold of income. Starting in 2013, individuals would not be subject to this tax until their modified adjusted gross income exceeds $200,000, or $250,000 if married filing jointly.
For this reason, it may be beneficial for overall tax purposes to pass income through from the estate to the beneficiaries so that it is taxed at a lower rate.
Form 1041, U.S. Income Tax Return for Estates and Trusts
Instructions for Form 1041, IRS
Publication 559, Survivors, Executors, and Administrators
Schedule K-1 (Form 1041), Beneficiary’s Share of Income, Deductions, Credits, etc.
Sonja Pippen, Ph.D., Income Tax Accounting for Trusts and Estates, Journal of Accountancy