A deceased estate involves legal and tax issues. Who gets what? And who pays the tax?
In this episode Michael McCarthy of Tax & Super Australia will walk you through the taxation of deceased estates. Here is what we learned.
We can’t talk tax without talking law, but we are not lawyers. So please ask your lawyer for proper advice. This is just to give you a first insight.
When you die, title to your property vests in your LPR. If your LPR is an executor, the title vests immediately upon death. If your LPR is an appointed administrator, title vests with the grant of letters of administration, but retrospectively as of the date of death.
The LPR now holds the assets in the estate for the benefit of the beneficiaries. Sounds like a trust? You are right. It is a trust. Your estate is a trust.
Legal Personal Representative
When you die, your legal personal representative (LPR) is either an executor or administrator. An LPR steps into your shoes.
When your will nominates somebody as your legal personal representative, this is the executor of your estate.
When you die without a will, a court will appoint an administrator as your LPR.
But depending on the assets in your estate, your executor or administrator will probably need to provide official proof that they are really your LPR.
A bank, for example, is not going to hand your $5m term deposit over to anybody who says you are dead and could they please have your money. The same applies to real estate, shares and a ton of other assets. The registry of those assets will want to see an official document showing that your LPR really is your LPR.
And this is where probate or letters of administration come into play.
Probate is a court order declaring your will as valid and hence confirming that the person you named as executor in your will really is your LPR.
Your executor usually can’t distribute your assets without such a grant of probate, unless the value of your estate is minimal. To obtain a grant of probate, your executor will apply to the Supreme Court for Probate. This application usually includes an inventory of all the assets and liabilities in your estate.
Letters of Administration
When you die without a will or when your will is invalid or when nobody can find your will, then you died intestate. In this case, a court needs to appoint an administrator as your LPR. This administrator will receive a letter of administration showing that they really are your LPR.
Only certain assets go into your estate. Assets that you held personally in your own name do. Superannuation interests and life insurance payouts might, but rarely do. Assets held in a family trust or company and jointly held assets don’t.
So units in a unit trust, shares in a corporate trustee and shares in a trading company will go into your estate if you owned these at the time of your death. But not the actual assets as such sitting behind this corporate veil.
The distribution of your super depends on the trust deed, binding death benefit nominations and beyond that the discretion of the trustee. So your super might be paid into your estate, but then again it might not.
Life insurance proceeds are paid out to the beneficiaries you nominated in your policy, but other factors play a role as well. So the proceeds might go into your estate, but often don’t.
Assets held jointly with someone else – be it a joint bank account, a joint home, a jointly held car or something else – pass automatically to the co-owner and don’t go into your estate. So if your estranged spouse is still on the title of your family home as joint tenants with you, they get the house no matter what your will says otherwise.
Distribution of Assets
The primary duty of the executor or administrator of your deceased estate is to collect your assets, pay your debts and distribute the residual to the beneficiaries. They are to make sure that your estate is preserved and properly maintained until all is distributed.
If you have a will, your executor has to distribute the assets according to your will. If you don’t have a will (intestacy), the relevant law in your state or territory will determine the order in which your eligible relatives will inherit your estate. In NSW that is the Succession Act 2006 (NSW).
So now you know who will step into your shoes as your LPR, what goes into your estate and how that estate is distributed. That is the legal side of a deceased estate. But what are the tax implications of all this?
There are three players involved in all this. You, your LPR and your estate’s beneficiaries.
Everything is business as usual until the day you die. You are liable for any tax on the income earned up to and including the day you die. Since you can’t do your final tax return, your LPR will – possibly with the help of a tax agent – if your income up to the date of death exceeds the tax-free threshold.
If CGT event K3 applies, your final tax return will include any capital gain or loss from this event.
Date of Death
The moment you die, your assets vests in your LPR. Your LPR is taken to have acquired the assets on the date of your death. You are no longer the legal owner of your assets. Your estate has come to life.
CGT Event A1
This change in ownership is a CGT event A1 under s104-10 (a). So this would potentially trigger a liability for capital gains tax, if there was no relieving provision. But there is.
Per s 128-1 any capital gain or loss upon transfer of assets from you as the deceased to your LPR is disregarded unless CGT event K3 applies.
CGT Event K3
The concessional treatment contained in Division 128 does not apply where a CGT asset passes to a ‘tax advantaged beneficiary’. A tax advantaged beneficiary could be, for example, an exempt entity, a complying superannuation fund (or ADF or pooled) or a foreign resident with respect to non-Australian taxable property.
So whenever a CGT asset goes to one of these, CGT K3 happens. So CGT event K3 is about a CGT asset leaving the Australian CGT regime.
When that happens, Australia will tax any capital gain straight away per s104-215 ITAA97. You as the deceased are taken to dispose of the asset to the tax advantaged beneficiary just before your death. And this capital gain is included in your final tax return.
After all this you are done. No more income or capital gains will come your way. The rest will be sorted out between the LPR and beneficiaries.
The big question for the LPR and beneficiaries is what happens to the cost base in a CGT event A1. The cost base will determine the capital gain the beneficiary might pay tax on one day. The answer depends on when you as the deceased bought the asset and what you used it for.
If you bought the asset before 20 September 1985, the market value at the time of your death becomes the asset’s cost base per s128-15. And the asset is no longer a pre-CGT asset in the hands of the LPR or beneficiary.
If you bought the asset after that date, your LPR usually inherits your cost base unless an exception applies.
One exception is your main residence. But the rules around main residences in deceased estates in s118-195 are quite detailed. As a general rule of thumb, the beneficiaries’ cost base for your assets usually adjusts to the market value at the time of your death.
Stages of Deceased Estate
In his ruling IT 2622 the Commissioner of Taxation (Commissioner) describes three stages in the administration of a deceased estate. Initial – Intermediate – Final.
In the initial stage the LPR is still working out what is what. What assets, what debts. The LPR uses income in the estate to reduce debt and pay expenses, but doesn’t really know yet how much will be left over when all of this is one and dusted.
In the intermediate state the LPR can foresee that there will be surplus assets in the estate. The LPR won’t need all assets to pay debts and expenses. So the LPR might start distributing some of the assets.
And in the final stage it is all clear and on the table. The LPR paid all debts and whatever the estate now earns is available for distribution. Plus the assets themselves of course.
A deceased estate is a trust and so Div 6 ITAA 36 applies. And with Div 6 comes the notion of ‘present entitlement’. Present entitlement is used to determine whether the LPR or the beneficiaries are assessable on the net income of the deceased estate.
The High Court ruled in FCT v. Whiting that a beneficiary is presently entitled to income of an estate when they can demand immediate payment of such income from the LPR. So the residuary beneficiaries of a deceased estate cannot be presently entitled to the income of the estate until it has been fully administered. Fully administered means that all funeral and testamentary expenses, debts, annuities and legacies have been paid or provided for in order that the amount of the residue can be determined.
However, a present entitlement may arise prior to the administration of the estate being finalised provided that adequate amounts have been set aside for these items and it is apparent part of the income of the estate will remain available for distribution.
The LPR obtains a tax file number for the estate, lodges tax returns and pays tax on the estate’s income at individual marginal tax rates per s99. It isn’t clear yet whether there will be any excess funds. The beneficiaries have no present entitlement and so are not assessed on any income.
While the LPR is still paying debt and working things out, the beneficiaries have no present entitlement. However, when the LPR determines that there are excess funds and stars to pay these out to beneficiaries, then the beneficiaries are presently entitled to the income actually received and s97 applies.
Now the beneficiaries of the estate have a present entitlement to the income of the estate. And so s97 ITAA36 applies to all income of the estate. The beneficiaries are assessed on the trust income unless under a legal disability. If that is the case, the LPR will pay the tax on that share of income.
Once everything is distributed, the estate comes to an end. The taxation of any further income from the distributed assets lies in the hands of the beneficiaries.
All this is just our brief take on the issue, but please listen to the episode above. Michael McCarthy explains all this in a much better way than we ever could.
Disclaimer: Tax Talks does not provide financial or tax advice. This applies to these show notes as well as the actual podcast interview. All information on Tax Talks is provided for entertainment purposes only and might no longer be up to date or correct. You should seek professional accredited tax and financial advice when considering whether the information is suitable to your or your client’s circumstances.
Last Updated on 04 May 2020