Question:

A distribution was made from the liquidation of an annuity in an estate in 2019. The estate income tax rate is 35.7% and  and the beneficiary who received the distribution and therefore k-1 income would be in a lower 24% bracket. After the lower tax is paid with personal proceeds, can the beneficiary then be reimbursed from the estate with another current distribution equal to the tax?

Response:

Usually estates have relatively low income and what income they earn is passed through to the ultimate beneficiaries who are likely to pay a lower tax rate as in the case you describe. However, the beneficiaries are not reimbursed for the taxes they do ultimately pay. It would be hard to make that work since presumably all the beneficiaries are paying taxes on the income that’s passed through to them, so the adjustments among beneficiaries should be relatively small. The cost of accounting for these may exceed the adjustments themselves.

In your case, due to the annuity, the income is much greater. You haven’t provided numbers, but the differential among beneficiaries would be based on their different tax brackets or if one or more heirs were beneficiaries of the annuity and others recipients of other assets that did not generate taxable income. Let’s run through a few possibilities:

Let’s assume that the estate holds $900,000 of which $300,000 is in an annuity for which the taxes are $50,000, and there are three beneficiaries.

Scenario 1:

The annuity if payable to the estate which is to be divided equally among all the heirs. In this scenario, they would all receive $300,000 and each would have a tax due of a third of $50,000, perhaps a bit higher or lower depending on their tax bracket.

Scenario 2:

The estate also goes equally to the three beneficiaries but the annuity doesn’t pass through the estate. It instead is payable directly to the three beneficiaries. It seems to me that this has the same result as Scenario 1. Each beneficiary pays a third of the tax, more or less, whether are not they are reimbursed by the estate. If they are reimbursed by the estate, the estate’s $600,000 would be reduced by the $50,000 in tax reimbursement reducing the estate distributions to the three beneficiaries to $183,333 each rather than $200,000. Everyone ends up in the same place.

Scenario 3:

The beneficiaries are different. The estate passes to beneficiaries A and B and the annuity passes directly to beneficiary C. In that case, A and B each net $300,000 (perhaps a bit less if they’re covering the probate costs) and C nets $250,000 after paying the $50,000 tax bill. The question, in that case, is whether this is fair. Should A and B pay some or all of the taxes? I’d argue no, that they shouldn’t. C received the annuity with it’s benefits and deficits. A and B received the other property with its benefits and deficits. Let’s assume that A and B inherited a house and they have trouble selling it, forcing them to pay real estate taxes, other maintenance expenses, potentially a decline in market value and, ultimately, a brokerage fee. Should C be forced to share in these costs? I think not. They should be borne by A and B.

 

Related Articles:

How Are My Trust Distributions Taxed?

What Are Estate and Trust Income Taxes?

Filing an Income Tax Return for an Estate