The Tax Effect on Deceased Estates

Although death duties were abolished in Australia many years ago, a number of tax issues remain which must be handled effectively by legal personal representatives (LPR) such as the administrators and executors of deceased estates.

Benjamin Franklin once famously said “In this world nothing is certain but death and taxes.” Beneficiaries often inherit tax liabilities along with bequeathed assets, however with careful planning these implications may be reduced.

What happens at death?

Following a death, the LPR must file a ‘date of death’ tax return for tax liabilities from the start of the financial year until death. A tax file number is then required to be obtained for the estate and a further tax return is required for submission for the period from death until the end of the financial year. Additional returns are required for each financial year until administration of the estate is completed.

As a separate tax-paying entity, with its own tax-free threshold, the estate can provide useful opportunities to minimise tax.

Capital gains tax

If an asset is inherited that the deceased purchased prior to September 1985, it will not be subject to tax upon death. However, the market value of the asset must be assessed at the date of death because when it is sold in the future, the beneficiary is subject to tax on any increase in value between the date of death and date of disposal.

If the deceased person purchased an asset after September 1985, the beneficiary will be liable for tax on the full capital gain since the date of purchase when the asset is subsequently sold.

Depending on the specific circumstances, it may be better for the estate to sell the asset, in which case it becomes liable for any CGT. With its own tax-free threshold, this may lead to a better outcome than passing the asset to a beneficiary who is on a higher marginal tax rate.

The family home of the deceased is the only asset exempt from CGT, provided it is sold within two years of the date of death, or if it becomes the principal residence of a beneficiary.

Tax on superannuation death benefits

If a superannuation death benefit is paid to a dependant of the deceased, it will be tax-free; however adult children rarely meet the definition of a financial dependent as defined by tax law.

The taxable component of a superannuation death benefit paid to a non-dependant as a lump sum is usually taxed at the recipient’s marginal tax rate. However, any applicable tax rebates can reduce this to an ‘effective rate’ of 17%. If a superannuation fund hasn’t paid tax on the taxable component (the untaxed component), it will be taxed at 32%. Advance planning may be able to reduce or eliminate tax on superannuation benefits.

Investment income

The assets of the estate will continue to earn investment income, which must be included in the estate tax returns for each financial year. Many accountants will advise that the estate be kept running for as long as the law allows, typically for two years, to take greatest advantage of this extra tax-free threshold. At some point in time this tax burden will need to be transferred to beneficiaries.

A Testamentary Trust would provide beneficiaries with much greater flexibility in relation to the allocation of investment income. It can also act to protect assets from risk of loss, which is helpful if the beneficiaries are going through divorce, have gambling or drug problems, or are at risk of bankruptcy.

The right advice

Dealing with taxes is never enjoyable, but it is made even more difficult when it relates to the death of a loved one. Establishing an effective estate plan can be complex so to ensure your beneficiaries are not put under extra strain see your financial adviser and plan now for the inevitable.

(Note: tax rates include 2% Medicare Levy.)