Deceased Taxpayer Income

I have a somewhat messy tax situation for a taxpayer whose father passed away in January of 2021. For 2021, the father had W2 and investment income, along with a trust that has investment income and a vacant land sale after his passing. So, there is a final 1040 filing and a trust return filing to be done for 2021. Seems fairly straightforward so far, as no distributions were made and the trust will owe some taxes. On the father's original W2, there were also some company stock included in Box 1 wages, with federal and state taxes withheld. To put some figures to it, the original 2021 W2 showed roughly $400k in wages, $90k in federal tax withholdings, and $20k in state withholdings. That $400k was roughly $100k in salary and $300k related to company stock. After getting the original W2, it was determined that the father's stock plan (the taxpayer calls it stock options, and I'm trying to confirm it wasn't RSU/Grants instead) had no beneficiary and had to go through probate and, therefore, an estate tax filing is also required for capturing that income. So, a 'corrected' W2 was issued that shows just the $100k of salary, however it didn't correct the withholdings and kept the full $90k federal tax withholdings under the taxpayer's SSN which will lead to a large refund if that is entered on his final 1040 filing. Along with the corrected W2, there is a 1099-B under the estate tax ID, now, that shows the other roughly $300k of short-term capital gains related to the stock options that had originally been shown on the W2 form. That 1099-B shows the same date for the 'acquire' and 'sold' date of the stock, which is November 18, 2021, so it's a STCG as shown on the 1099. So, there are now 3 returns to be filed (1040, trust, estate) and some things I'd like any thoughts on:
1. For filing the father's final return, it seems like the corrected W2 did not properly account/adjust for the tax withholdings (ie- W2 Box 2 for federal withheld and Box 17 for state withheld) that were related to the stock that is being reported on the estate return, and if I file using that W-2c information then there will be a large 1040 refund, but a large estate tax balance owed (plus penalty/interest). I have the deceased father's final paystub that shows about $20k of that federal withholding was taken from his paychecks, which would leave about $70k that could be related to the stock income to be reported on the estate return. Should another W-2c be requested to correct the federal/state withholdings? If so, part of me thinks the returns should be filed now using the withholdings as they should have been reflected on the 1040/estate returns ($20k on 1040 and $70k on estate), as it took over 6 months for this corrected W-2c to be received.
2. If the stock received were stock options, wouldn't those ordinarily not be run through your paycheck? It seems like only RSUs or grants would be run through the employee's W2, with withholdings taken out? If these were truly stock grants/RSUs, instead of stock options, should they possibly have remained on the W2 as income reported on the taxpayer's final return, and then just the small capital gain/loss would be reported on the estate return when those were later sold in November 2021?
3. The vacant land that the father owned and that the trust later sold was purchased one month before the father passed away. I'm not sure if there is a step-up/down in basis, but absent any other figure would it be reasonable to just use the purchase price as cost-basis for the land sold by the trust, since it was purchased so close to the date of passing?

Thoughts on any other considerations here? Thanks

Along with the corrected W2, there is a 1099-B under the estate tax ID, now, that shows the other roughly $300k of short-term capital gains related to the stock options that had originally been shown on the W2 form. That 1099-B shows the same date for the 'acquire' and 'sold' date of the stock, which is November 18, 2021, so it's a STCG as shown on the 1099.

Be careful here. Often we see Forms 1099-B which do not include basis resulting from income recognized on the exercise of non-qualified stock options. This is consistently with IRS instructions, although obviously not helpful - although usually that additional basis will be reported in the accompanying supplemental information. So your short-term capital gain should be quite small (or maybe a small loss). Since they took the $300k of income off of the W-2, I would think that you'll have a Form 1099-MISC for the estate for $300k (which would be the same income that gives you basis in the stock).

1. For filing the father's final return, it seems like the corrected W2 did not properly account/adjust for the tax withholdings (ie- W2 Box 2 for federal withheld and Box 17 for state withheld) that were related to the stock that is being reported on the estate return, and if I file using that W-2c information then there will be a large 1040 refund, but a large estate tax balance owed (plus penalty/interest). I have the deceased father's final paystub that shows about $20k of that federal withholding was taken from his paychecks, which would leave about $70k that could be related to the stock income to be reported on the estate return. Should another W-2c be requested to correct the federal/state withholdings? If so, part of me thinks the returns should be filed now using the withholdings as they should have been reflected on the 1040/estate returns ($20k on 1040 and $70k on estate), as it took over 6 months for this corrected W-2c to be received.

No, the income tax withholdings are going to stay the same. It sounds like the W-2c is correct.

2. If the stock received were stock options, wouldn't those ordinarily not be run through your paycheck? It seems like only RSUs or grants would be run through the employee's W2, with withholdings taken out? If these were truly stock grants/RSUs, instead of stock options, should they possibly have remained on the W2 as income reported on the taxpayer's final return, and then just the small capital gain/loss would be reported on the estate return when those were later sold in November 2021?

It depends. Non-Qualified Stock Options also show up on the W-2, when they are exercised.

3. The vacant land that the father owned and that the trust later sold was purchased one month before the father passed away. I'm not sure if there is a step-up/down in basis, but absent any other figure would it be reasonable to just use the purchase price as cost-basis for the land sold by the trust, since it was purchased so close to the date of passing?

Yes. Plus closing costs on the sale.

Should another W-2c be requested to correct the federal/state withholdings?

No. Don’t bother. Sounds like the options (if that’s what they were) went through the estate and were exercised post-death. I’d consider a 645 election and a fiscal year-end.

Thanks for the input and the mention of the 645 election. So, I did confirm the investments were nonstatutory stock options received in 2018 and 2020, but not exercised until 10 months after the taxpayer’s death in 2021. In looking at Revenue Ruling 64-150, it seems the W-2 for the taxpayer should capture the FICA wages and FICA tax withheld for the exercised options since they were exercised in the same year he died (and should not have been subject to income tax withholding), and then there should also have been a separate 1099-MISC ‘other income’ issued to the estate. The estate has the 1099-B form, but has not been issued a 1099-MISC. In looking at the stock option confirmation statements, though, I can see that the option exercise price is shown in the cost basis on the estate 1099-B, so it does appear the basis is correct there despite not having received a 1099-MISC form. Given the tax rate is the same ordinary income tax rate whether reported to the estate through 1099-B as STCG or a 1099-MISC form, I don’t think not having a 1099-MISC will make a difference in this case, as the taxable income seems to be correct given the basis is right. The stock option confirmation statements also show the federal and state taxes withheld of $70k and $20k, which I mentioned previously. Since those withholdings are still being reported on the corrected W-2c, the final thing to confirm is that those were made under the deceased SSN and not the estate tax ID. Assuming the federal and state withholdings are all under the deceased SSN, I’m left with filing the final 1040 and getting roughly $80k in a federal tax refund ($100k of income, with $90k federal withheld), but then turning around and owing about $125k on the estate tax return for the $300k of income reported there (since the estate STCG income is subject to ordinary income rates and quickly hits the 37% tax bracket plus some NIITs). Alternatively, if those taxes happened to have been paid under the estate then the taxpayer would get a smaller $10k federal refund, but then the estate would 'only' owe about $55k. Net total would be roughly $45k owed between the 2 returns, regardless.

None of what you say is accurate if a 645 election can be made. The issue there will be the timeliness of it. I don’t know what you did in terms of filing extensions. And I don’t know what the plan is with the trust, to keep it around or not.

With that said, if these stock options were really part of the estate – which you say they were – then can’t you just use a 10/31/21 year-end for the estate? If so, you’d have a late initial return for the estate fye 10/31/21. But that return might not have a lot on it. In fact, a filing might not even be required fye 10/31/21. And then what you’d do is have the estate collect the option income in 11/2021 (which has already happened). And then, prior to 10/31/22, the estate would distribute that cash to the trust and issue a K1 to the trust. This K1 will be picked up on the trust’s 12/31/22 calendar year tax return. And then what you do, prior to 12/31/22, is distribute out of the trust, to the trust beneficiaries and issue the beneficiaries K1’s. Now you have moved the income off of the estate and trust tax returns and have avoided the awful tax rates associated with those entities. This is basically a workaround if a 645 election is a no-go. It also assumes that actually making distributions to ultimate beneficiaries is in the cards (i.e. there is no long-term intent to keep the trust around).

And I don’t know what you’re talking about with respect to the STCG. The option gain is ordinary/compensatory. If the options were exercised and immediately sold, there will be very little capital gain or loss on the actual sale of the stock.

Extensions were filed/accepted for the trust and estate, but they were filed with a calendar year instead of a fye and they would not have been considered 'timely' if the fye of 10/31/21 had been chosen instead (in other words, they weren't filed by Feb 15th, 2022).

So, if you forgo the option of a 645 election, could the estate still file a tax return with a 10/31/21 fye, given that the extension was filed using a calendar year? If so, then a late filing for the initial return using that 10/31/21 fye might make sense to establish the 10/31/21 fye, even though the filing isn't required because the estate had no income up to that point. Then that would allow the income from the stock options to be distributed to the beneficiaries prior to the final 10/31/22 tax return filing. You mention distributing the cash to the trust and then to the beneficiaries, but assuming the trustee agrees, couldn't it go directly to the beneficiaries? Would the distribution of that income to the beneficiaries in 2022 be part of their 2022 individual tax return filings given the estate's fye, even if the income for the trust was received in November 2021?

In regards to the STCG, I was calling it that because the only tax from the estate received was a form 1099-B showing STCG. I think they should have also received a 1099-MISC for the compensation and that would increase the basis of those exercised options that were immediately sold. Since no 1099 was received, would I report this as 'other income' for the estate on form 1041, line 8, and then increase the basis which would leave little to no capital gains?

On an initial Form 1041, you can choose whatever fiscal year end date you want. But your extension is valid only for the fiscal year end shown on the extension (12/31/2021). So you can file a 10/31/2021 return, but it will be delinquent.

Is a 645 election possible on a return that isn't filed timely?

In regards to the STCG, I was calling it that because the only tax from the estate received was a form 1099-B showing STCG. I think they should have also received a 1099-MISC for the compensation and that would increase the basis of those exercised options that were immediately sold. Since no 1099 was received, would I report this as 'other income' for the estate on form 1041, line 8, and then increase the basis which would leave little to no capital gains?

Yes, it sounds like that's what should happen.

So, if you forgo the option of a 645 election, could the estate still file a tax return with a 10/31/21 fye, given that the extension was filed using a calendar year?

Yes, of course. Year-end is based on what you put on the initial return, not what you may have put on an extension.

If so, then a late filing for the initial return using that 10/31/21 fye might make sense to establish the 10/31/21 fye, even though the filing isn't required because the estate had no income up to that point. Then that would allow the income from the stock options to be distributed to the beneficiaries prior to the final 10/31/22 tax return filing.

You’re catching on.

You mention distributing the cash to the trust and then to the beneficiaries, but assuming the trustee agrees, couldn't it go directly to the beneficiaries?

Mechanically, yes. But for return reporting purposes, if the bene of the estate was the trust, you’d want to report the distribution as having gone first to the trust and then from the trust to the benes. And a K1 should go from the estate to the trust. If you do otherwise (i.e., just issue K1’s from the estate to the individual benes) that would improperly ignore stuff inside the trust, which might be carried out with a distribution, and thus, you end up with improper reporting.

Would the distribution of that income to the beneficiaries in 2022 be part of their 2022 individual tax return filings given the estate's fye, even if the income for the trust was received in November 2021?

I already answered this above when I said:

And then, prior to 10/31/22, the estate would distribute that cash to the trust and issue a K1 to the trust. This K1 will be picked up on the trust’s 12/31/22 calendar year tax return. And then what you do, prior to 12/31/22, is distribute out of the trust, to the trust beneficiaries and issue the beneficiaries K1’s.

The bene picks things up based on the year-end showing on the K1. In this case, the bene is the trust, who has received a K1 from the estate and that K1 shows a 10/31/22. So, as I stated, it would be picked up on the trust’s 12/31/22 calendar year return. This is a common planning maneuver.

Since no 1099 was received, would I report this as 'other income' for the estate on form 1041, line 8, and then increase the basis which would leave little to no capital gains?

Yes. And make sure you report things on Form 8949 to avoid an IRS notice.

At present, you are stuck with trust/estate tax rates. I understand you have a big balance due here and big refund there. Nonetheless, you have not avoided the high trust/estate tax rates. The only thing different about your two current situations (wrong withholding vs right withholding) is potential penalties (and interest). But penalties could probably be waived. That is (the penalties) the only thing that moving the withholding around will impact. Now fast forward to the ideas I have presented: Those ideas will actually get you out of the high trust/estate tax rates. I don’t know for sure – because I don’t know the tax brackets of the individual benes – but I suspect there could be quite a bit of tax savings if we can avoid the trust/estate tax rates.

Now, maybe you changed your post, because I could have sworn you said something like, “The trust will stick around. We will not be able to distribute to benes.” If that really is the case, then you’re stuck. But if it is not the case and if big distributions can be made to the benes, you could look like a hero. So this is definitely something that should be explored. What exactly are the family dynamics here? If you did say the trust will stick around, what are the primary reasons for it? And do those reasons outweigh what might be considerable tax savings?

Out of curiosity, I would look to know the answers to the above questions, plus…I’m not sure if the decedent had a surviving spouse. Is there one of those? Is this a second marriage?

I’m just thinking that if we have responsible beneficiaries (including adult children and maybe a surviving spouse) and no one has creditor problems, no one is on drugs, and we think the money would be safe with these folks, no one would be screwed with all this maneuvering and we are not disregarding the decedent’s wishes, then distributing to save taxes is something to seriously consider.

As a piece of advice, any time you have a decedent die, with a living trust, you need to be thinking about a 645 election so that if one is needed, it is made timely.

So you can file a 10/31/2021 return, but it will be delinquent.

Right, assuming a return is even required. If it’s not, 10/31/22 will be the initial return for the estate. Sounds like, as to the estate, the only real “assets” that weren’t titled to the trust were the stock options and that income hit in 11/2021. Maybe there was a personal bank account, but whatever.

Is a 645 election possible on a return that isn't filed timely?

We’re not suggesting a 645 election any longer. All the maneuvering above involves two separate entities (estate and trust) and two separate returns

Jeff-Ohio, Really appreciate you taking the time to share your input here. Was out of town a few weeks and getting back into things, but will dive into what you wrote to see what options might be available to pursue here.

Out of curiosity, I would look to know the answers to the above questions, plus…I’m not sure if the decedent had a surviving spouse. Is there one of those? Is this a second marriage?

Regarding the questions:
1. There is a trust that will remain in place with limited distributions (not really sure why, as the kids are older and seem responsible), but the estate has a court appointed rep, the daughter, who plans (and all others are in agreement) to distribute the estate directly to the 2 beneficiaries and bypass the trust. There doesn't appear to be anything that would require it to be run through the trust first, as opposed to being distributed directly to the beneficiaries.
2. There is no surviving spouse, so that isn't an issue.

So, I'm moving down the path to choose the 10-31 fye, and to distribute that income to the beneficiaries before 10-31-22, so the lower individual tax rates are paid on that income. Does it make sense to file an estate return for 10-31-21 to establish the estate fye, even if there isn't enough income to require that filing?