Tax Planning Strategies for Terminally Ill Individuals and their Families

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Terminally ill individuals often desire to benefit the people and institutions they love by means of actionable and effective tax planning, even in the final period of their life.

These taxpayers, their families, and their tax advisors may be motivated to take advantage of situational tax planning opportunities when faced with the difficult challenges of a terminal illness. This article will describe several planning strategies centered around the following concepts:

Most opportunities related to pre-mortem tax planning require knowledge of the following related to ill taxpayers (and their spouse, if married):

Leveraging Asset Basis

Unrealized losses offer tax planning opportunities. Based on circumstances, taxpayers should consider the following options:

The tax basis of all assets held by a taxpayer at the time of death is generally adjusted to the fair market value at the date of death, or the alternative valuation date (AVD), if elected. Although this concept is referred to as a “stepped-up” basis, the corollary impact is that any asset that has an unrealized loss actually receives a “stepped-down” basis equal to the fair market value of the assets as of the applicable valuation date. If a taxpayer is married, consideration should be given to having the healthy spouse transfer low-basis assets to the ill spouse to garner the benefit of a stepped-up (higher) basis upon the anticipated passing of the ill spouse.

In most cases, it is recommended that investments with a low basis (and a large unrealized capital gain) should be held by the ill taxpayer in order for the estate to receive a step-up in basis. At the same time, advisors must be cognizant of the rules of IRC section 1014(e), which provide that where property is gifted by a donor to the decedent within the one-year period ending on the decedent’s date of death, and such property passes from the decedent to the donor (or donor’s spouse), the basis of the property to the donor (or donor’s spouse) is equal to the adjusted basis of the property in the hands of the decedent immediately before death.

Safeguarding the Use of Tax Attribute Carryovers

Three very common tax attribute carryovers that expire at death are realized capital losses, charitable contribution carryovers, and realized net operating losses. These attributes will expire with the filing of the taxpayer’s final income tax return for the year of death, even when the taxpayer is married and married filing jointly status is elected. When capital losses, charitable contributions, and net operating losses are initially recognized, they are reported by the individual taxpayer. If the disposed property is jointly owned, 50% of the loss or deduction is allocated to each taxpayer included on the joint return.

Net capital losses are deductible against ordinary income up to $3,000 annually and are carried forward indefinitely, only expiring at the later of the tax year in which they are fully consumed, or the tax year that includes the taxpayer’s death. If a capital loss carryforward of more than $3,000 exists for an ill taxpayer, the best tax planning solution is to generate sufficient capital gains to utilize the loss. Spousal gifts of low-basis appreciated assets to the ill spouse should be considered.

Unused charitable contribution deductions also carry forward and expire upon the earlier of five years after the tax year in which the contribution was originally made, or at the taxpayer’s death. A taxpayer can only benefit from the charitable contribution deduction if they elect to itemize deductions. Due to the near doubling of the standard deduction allowed under IRC section 63 by the Tax Cuts and Jobs Act of 2017 (TCJA), more taxpayers are taking the standard deduction and fewer taxpayers are electing to itemize deductions. Charitable contributions to public charities are generally deductible up to 50% (60% through December 31, 2025) of adjusted gross income (AGI) for cash and 30% of AGI for donations of appreciated long-term capital gain assets.

In order to optimize the deduction for charitable contributions of capital gain property, consideration should be given to the special election under IRC section 170(b)(1)(C)(iii), under which a taxpayer can permanently elect to forgo a charitable contribution deduction of the appreciation on capital gain property, while simultaneously enabling the taxpayer to utilize the 50% limitation. A current-year election under IRC section 170(b)(1)(C) (iii) will also impact the treatment of contribution carryovers (for which an election was not made in a prior tax year) on the current year’s return.

If a charitable contribution carryfor-ward exists, increasing income on the final income tax return may be beneficial. Methods of increasing income include increased withdrawals from traditional retirement accounts, conversion of traditional 401(k) or IRA accounts to Roth 401(k) or Roth IRA accounts, realizing capital gains, redeeming U.S. savings bonds, and a conversion or a withdrawal from a tax deferred annuity.

In another change from the TCJA, net operating loss (NOL) carryforwards now have an indefinite life, with unused losses expiring only upon the taxpayer’s death. If a NOL carryforward exists, consideration should be given to either 1) increasing taxable income on the taxpayer’s final tax return or 2) reducing and shifting deductions away from the ill taxpayer. For example, it may be beneficial to have the estate or spouse pay state and local taxes, investment management fees, mortgage interest, and medical expenses, or to not make any charitable contributions. These actions can help utilize the loss carryforward on the final income tax return of the ill taxpayer subject to the TCJA threshold.

Not as common, but still relevant, is the treatment of suspended passive activity losses and passive activity credits. When a taxpayer’s interest in a passive activity is transferred by gift, the suspended losses increase the donee’s basis in the property. Although the donor will not realize a benefit from these losses, the donee may realize less gain on a subsequent sale of the related asset.

When a taxpayer’s interest in a passive activity is transferred at death, the suspended losses are only allowed on the decedent’s final tax return to the extent, if any, that the suspended losses exceed the step-up in basis for the related assets. Suspended losses that are equal to or less than the amount of the step-up in tax basis are lost. Suspended passive activity credits not used on the decedent’s final return are also lost.

A sale of the passive activity is also a consideration, as a complete disposition will allow a suspended passive activity loss to be utilized on the ill taxpayer’s final income tax return. Selling a passive activity may be a more complex undertaking and require a longer planning horizon than may be available depending upon the expected mortality of the ill taxpayer.

Tax Planning Alternatives for the Taxpayer and Beneficiaries

In the year of a taxpayer’s death, three tax returns may be available for tax planning: the taxpayer’s final income tax return, the estate’s income tax return, and the beneficiaries’ income tax return. The potential difference in marginal income tax brackets among these multiple taxpayers offers many tax planning opportunities. The collective tax liability of the applicable taxpayers may be affected depending upon how the taxable income is sourced or allocated among these returns. Of particular note is that the highest income tax rate of 37% begins at vastly different taxable income levels for individuals than it does for estates and trusts. These differences lead to the following planning considerations:

Actions should be taken to ensure that the lowest tax brackets (currently 10% and 12%, which will expire as of December 31, 2025) are fully utilized on the final tax return. Taxable income can be increased by both generating income (similar to those methods listed in the discussion of charitable contribution carryforwards) and limiting deductions (similar to those methods listed in NOL carryforwards).

If the taxpayer has a traditional IRA or 401(k) account, the taxpayer could take a pre-death distribution [required minimum distribution (RMD) or supplemental distribution] if they are in a lower tax bracket than the intended IRA beneficiary. If the beneficiary is in a lower tax bracket, it would be more advantageous for the beneficiary take the distribution rather than the taxpayer take the distribution pre-death, A taxpayer under 73 who does not have a required minimum distribution may also consider conversion from a traditional IRA to a Roth IRA depending upon the relative income tax bracket of the account owner and the beneficiary. In the case of a taxable estate, there can also be estate tax benefits to a Roth conversion, as a portion of the estate is consumed by the income taxes due upon the Roth conversion.

If the taxpayer has a tax deferred annuity contract that has not been annuitized, consideration should be given as to whether the taxpayer or beneficiaries will be in the lower tax bracket, both in the current year and over the next five years. Distributions (withdrawals) from a non-annuitized annuity contract are included in the taxpayer’s gross income until all the gain in the contract has been distributed. Taxpayers have the opportunity to make a withdrawal and report the income on their final return if they are in a lower tax bracket than the beneficiary. Alternatively, beneficiaries can take periodic distribution or may defer the income for up to five years, as long as they fully liquidate the contract by the fifth anniversary of the taxpayer’s death [IRC section 72(s)].

U.S. savings bond interest will be taxed to the taxpayer if the bonds are redeemed before death. Otherwise, the estate or the beneficiaries must report the income as income in respect of a decedent (IRD). There are deductions available if the estate is taxable for federal purposes and the IRD is included in the taxable estate. If it is advantageous, the executor can also redeem the savings bonds and make an election to have the interest income taxed on the decedent’s final income tax return (Revenue Ruling 68-145).

Mutual fund capital gain distributions received after the taxpayer’s death will be reported on the estate’s income tax return and be taxed either to the estate or the beneficiary (if the income is distributed, if the account has a beneficiary designation, or if it is transferred upon death). This situation may also provide an ancillary tax planning opportunity to recognize a capital loss, in that the mutual fund tax basis should have been stepped up to fair market value as of the date of death, while the fair market value of the mutual funds (after the capital gains distribution) will likely have dropped. This unrealized capital loss can be then utilized at an opportune time.

Estate Income Tax Return Planning Strategies

Given the current estate tax exemption ($13, 610,00 in 2024), most taxpayers are not subject to the federal estate tax. Nevertheless, the estate will often incur administrative expenses, including fiduciary, attorney, accounting, and tax preparer fees. These expenses can be deducted on the estate income tax return if they are not deducted on the federal estate tax return. These expenses can extend over more than one tax year. As such, it may be beneficial to plan to generate income within the estate sufficient to utilize these expenses. In anticipation of these deductions, designating the estate as a partial beneficiary of an IRA account could be a way to efficiently use these deductions when other income cannot be triggered. Alternatively, the expenses can be paid in the final year of the estate.

Prior to the TCJA, the estate could distribute excess administrative expenses to the beneficiaries in the final year of the estate; these excess deductions would then have been treated as a miscellaneous itemized deduction subject to a 2% AGI floor. Following the passage of the TCJA, it initially appeared that new IRC section 67(g) prohibited these excess deductions, because the TCJA specifically prohibited such 2% miscellaneous itemized deductions incurred from 2018 to 2025. In late 2020, however, the Department of the Treasury issued final regulations under IRS sections 67 and 642, which provide guidance on determining the character of the deduction that will be reported to a beneficiary on Form K-1. Now, upon termination of an estate, each distributed deduction retains its true “tax character” on the beneficiary’s tax return as either:

Specifically, IRC section 67(e) removes the deductions described in section 67(e) (1) and (2) (deductions for costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such estate or trust) from the definition of itemized deductions under section 63(d), and thus from the definition of miscellaneous itemized deductions under section 67(b), and treats them as deductions allowable in arriving at AGI under section 62(a).

Even before TCJA, estates had very low taxable income thresholds before the highest income tax rates applied. As a result of TCJA, the highest 37% rate applies to ordinary income in excess of $15,200 in 2024. Qualifying dividends and long-term capital gains would be taxed at a maximum tax rate of 20%. Given the lower thresholds at which the maximum ordinary income and long-term capital gain rates apply for the individual beneficiaries, the executor should strategically distribute income to minimize the overall tax burden to the affected parties. On the other hand, it is equally possible that very modest estates may be able to utilize the 0% rates applicable to qualifying dividends and long-term capital gains when estate taxable income does not exceed $3,100 in 2024.

Deathbed Strategies for a Planned Gift

Some taxpayers have a desire to make a material gift to a valued charity on their passing that they have not previously addressed through a vehicle such as a charitable remainder trust or charitable lead trust. Some rudimentary approaches include naming the charity in the taxpayer’s will, or naming it as a beneficiary of a tax deferred asset such as a traditional IRA, an annuity, or a life insurance policy. Each of these simpler vehicles can have advantages, but as the actual date of death approaches, the ideal vehicle to use can differ from the one initially chosen.

Unless a taxpayer is subject to the federal estate tax, using a testamentary bequest (will) or a life insurance policy beneficiary designation for a planned gift offers substantively no tax benefit to the donor, their estate, or their beneficiaries. To generate some possible tax benefit, consideration can be given to making the gift from their IRA or tax deferred annuity. Both traditional IRAs and tax deferred annuities are IRD-laden assets whose income will be taxed as ordinary income to the beneficiary; it is better to use these tax-heavy assets to fund charitable gifts. Alternatively, the taxpayer could make the planned gift personally and recognize the deduction on their final income tax return. Depending upon how overall tax planning will be optimized, consideration should also be given to using the mechanism of qualified charitable distributions under IRC section 408(d)(8).

Change in Future Tax Filing Status of Spouse

If a terminally ill taxpayer is married with no dependents, the surviving spouse will experience a change in tax filing status from married filing jointly in the year of death to single in the next tax year. The increase in tax rates as a result of this change can be significant.

Accelerating income or deferring deductions may be prudent when one anticipates an increase in tax rates. As noted earlier, income can be increased by taking a larger withdrawal from an IRA or tax deferred annuity, cashing in savings bonds, or generating capital gains. Deductions that can potentially be deferred include charitable contributions, the state and local income and property taxes, and medical expenses.

Other Tax Planning Items

Other tax planning items for consideration would include current-year funding of a traditional IRA, SEP-IRA, Roth IRA, health savings account, section 529 plan, or donor-advised fund. If these opportunities exist, they probably offer tax benefits, and they should not be overlooked.

Final Thoughts

Many planning ideas can work one day and be ineffective the next. When a terminal illness becomes part of a taxpayer’s daily reality, most tax ideas leave the realm of the theoretical, and practical decisions need to be made. Potentially significant tax savings can be realized when good ideas are matched with timely execution.

David J. Hess, CPA is an assistant professor of accounting at Robert Morris University, Moon Township, Pa., and a principal in the CPA firm, Frank P. Hess & Co., Inc., Pittsburgh, Pa.

Carol S. MacPhail, CPA, CFP is an associate professor of accounting and finance at Robert Morris University, where she also directs the financial planning program. She is retired from Deloitte LLP, where she was partner in the public utilities and energy practice.