What Really Happens in Probate? Part Three

Written by Jim Worthington on September 22, 2018

The preceding two articles talked about getting appointed by the probate court and marshalling the estate assets and paying creditors’ claims. This article will discuss paying taxes, paying the beneficiaries, and closing the estate.

Estates must pay income taxes if they receive $600 of income in a fiscal year. The income tax returns for an estate are filed using IRS Form 1041 and Kentucky Form 741. Unless the estate’s income is very simple, such as strictly interest, the returns should be prepared by an attorney, CPA, or enrolled agent. One reason for this is that some tax planning can be done during the administration of an estate to distribute taxable income to beneficiaries, reflected on a Form K-1; beneficiaries may pay tax at a lower marginal rate than the estate would. In addition, the timing of when expenses are paid can affect the potential tax due.

Hopefully, the estate will be large enough to pay everybody. But, just as there was an order of preferences when paying creditor claims, there is an order of preferences when paying beneficiaries, which follows:

  1. If someone is left specific property or funds from a specific source, the latter of which is called a demonstrative bequest, the personal representative makes those distributions.
  2. If someone is left a specific bequest of an amount of money, the personal representative makes those distributions.
  3. The personal representative distributes what remains to the residuary beneficiaries. This is the only bequest that takes place when there is no will.

Once everyone is paid—or has received everything the estate can pay, there are three ways to close the estate: a formal settlement, an informal settlement, or a proposed settlement.

In a formal settlement, the demonstrative and specific bequest beneficiaries sign receipts (or the personal representative presents cancelled checks) and the personal representative prepares a penny by penny accounting of every receipt and expense of the estate. The expenses include the personal representative’s fee, if he or she took one, and any professional fees for appraisers, tax return preparers, and attorneys. The personal representative submits this to the District Court, which reviews it in detail and frequently rejects the first submission and requires additional explanation and documentation. Because of the time involved in that type of review and the staffing of most District Courts, that process can take several months.

In an informal settlement, the demonstrative and specific bequest beneficiaries sign receipts (or the personal representative presents cancelled checks) and the residuary beneficiaries waive the formal settlement. This means that the personal representative doesn’t have to accountto the courtfor every penny spent. Sometimes, the residuary beneficiaries ask to see the accounting but don’t rely on the court to approve it. That can save the estate money because even if the beneficiaries and the court have the same question, it is usually less cumbersome and thus less expensive to answer it for the beneficiaries. Even if the residuary beneficiaries approve the way the estate was handled by signing the waivers, the District Court still reviews the personal representative and attorney fees to make sure they are reasonable. Unlike the several-month waiting period for formal settlements, informal settlements are typically approved in as little as a week.

The proposed settlement is like the formal settlement in that it involves a penny by penny accounting as well as receipts or cancelled checks from the demonstrative and specific bequest beneficiaries. The difference is that it is submitted before the distributions are made to the residuary beneficiaries rather than after. The District Court then holds a hearing in open court to give everyone a chance to object.

The proposed settlement is a useful tool in two cases. One is when the estate is insolvent, i.e., the estate doesn’t have enough money to pay all of its creditors and/or demonstrative and specific bequest beneficiaries. It is also useful when the personal representative anticipates that one or more beneficiaries will object to the handling of the estate. Questions can be resolved more quickly and with less risk of the personal representative’s liability than with a formal settlement.

Once the final tax returns are filed, the creditors are paid, the beneficiaries receive their inheritance, and the settlement is approved, the District Court will enter an order discharging the personal representative from further responsibility for the estate. The estate is then considered closed.

On occasion, that is not the end of the story. Despite the personal representative’s best efforts to find everything, a new asset may show up even years later. When that happens, the estate can be re-opened for the limited purpose of administering that asset.