Death and taxes may be inevitable, but what about taxes after death? If you pass away with a tax liability, the IRS can keep on coming with notices, liens, levies and the entire arsenal of heavy collection weaponry. The target shifts slightly, however, with your heirs and representatives now dealing with the tax issues, and your estate holding the legal liability.
At the time of your death, your personal obligation to pay income tax ends and your assets become an "estate." An estate may include money, investments, real estate and other resources, some of which generate taxable income and/or remain taxable property. The tax obligations pass to the estate, and the administrator of the estate becomes the person responsible for filing tax returns and paying taxes out of estate assets. If you have not appointed an administrator or executor to handle your estate, the obligation passes to an individual appointed by a probate court.
When you die, the IRS asserts a lien against the assets of your estate. A federal tax lien along with other debts must be satisfied out of these assets before any of the property can pass to your heirs. The law does not require the IRS to notify anyone of the lien: It's just there, legally, and follows the property if that property passes to the heirs and the tax remains unpaid. Setting up a trust, which names beneficiaries and allows the estate to avoid probate, does not nullify tax obligations.
Your administrator is going to have to deal with a final income tax return, for the year of your death, as well as an estate tax return. The estate tax is levied against the value of estate assets, not on income; federal law sets an exemption amount, below which your estate will not owe any estate taxes (that amount stood at $5.12 million as of 2012).
Certain estate property is exempt from income tax levies. This includes the proceeds of life insurance policies, workers' comp and unemployment benefits, and a limited amount of household goods, clothing, tools, books, furniture and real property. If an estate has insufficient non-exempt assets, then the administrator can negotiate with the IRS to reduce the lien. If, however, the administrator transfers assets to heirs without paying tax liabilities, then the IRS (and state tax agencies) will come after the administrator, personally, for the back taxes.
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