When someone dies with a living trust, the successor trustee has plenty to do. There are assets to collect, bills to pay, and eventually distributions to make to the beneficiaries. And somewhere along the way, somebody has to deal with the taxes.
In most of our trust administrations, the successor trustee is one of the deceased parent's children. He or she has probably never administered a trust before, much less dealt with the tax returns that may be required.
Fortunately, the trustee doesn't have to prepare the returns. That's why we have CPAs. But the trustee does need to make sure the tax work gets done, provide the CPA with the necessary information, and keep enough money in the trust to pay whatever taxes may be owed.
There are three federal tax returns that may come into play: the decedent's final income tax return (Form 1040), a federal estate tax return (Form 706), and the trust's income tax return (Form 1041). California has its own income tax returns as well.
Here's what the successor trustee needs to know about each of them.
Probably not.
The federal estate tax exemption for someone dying in 2026 is $15 million. Most of our clients have estates less than that.
In determining the value of the estate for federal estate tax purposes, you don't just add up the assets in the living trust. The estate may also include retirement accounts, life insurance, jointly owned property, and other assets outside the trust. Certain taxable gifts made during the decedent's lifetime also count toward the filing threshold.
For most families, the federal estate tax won’t be an issue. But what about state estate taxes?
Unlike many states, California doesn't have an estate tax or inheritance tax for current deaths, either. For once, California gives us a tax break.
We've discussed the current federal estate tax exemption in our article on the estate planning law changes for 2026.
Although most estates won't owe estate tax, there are situations where an estate tax return should be filed anyway. I'll explain those shortly.
The first return to deal with is the decedent's final personal income tax return.
Suppose Mom died on June 15. Her final federal Form 1040 reports her income from January 1 through June 15. This would include the usual items: pension income, taxable Social Security, interest, dividends, retirement account distributions, and whatever other taxable income she had.
The return is generally due in April of the following year. A final California income tax return, Form 540, may also be required.
The trustee should find out whether Mom filed her returns for prior years. If she didn't, any required prior-year returns will need to be filed as well.
We generally recommend that the trustee use Mom's regular CPA, assuming she had one. That CPA already knows her finances and has her prior returns. There's no reason to start over with someone new.
The final 1040 reports Mom's income through the date of death. Income earned by her trust after she died is handled separately.
Form 706 is the federal estate tax return. For a U.S. citizen or resident dying in 2026, the return is generally required when the gross estate, adjusted taxable gifts, and any applicable specific exemption exceed $15 million.
But there's another reason to file Form 706, even if the estate is below the exemption. Actually, there are two reasons, both involving married couples.
Suppose Mom dies first, leaving everything to Dad. Her estate is worth $4 million. There isn't any estate tax to pay, so why would Dad bother filing an estate tax return?
Because he may want to preserve Mom's unused estate tax exemption.
This is called portability. Federal law allows the surviving spouse to use the deceased spouse's unused estate tax exemption in addition to the survivor's own exemption.
But it doesn't happen automatically. The estate generally needs to file Form 706 and make the portability election.
Is that worth doing when Mom's estate is only $4 million?
Maybe. If Dad is 85 and his estate is unlikely to approach the exemption, probably not. But suppose Dad is 55, owns substantial real estate, or has investments that could appreciate significantly over the next 30 years. Preserving Mom's unused exemption may turn out to be a very good decision.
A Form 706 is ordinarily due nine months after death, although a six-month extension is generally available. The IRS also allows certain estates that weren't otherwise required to file to make a late portability election within five years of death.
I wouldn't rely on the late-election procedure. The better practice is to consider portability during the administration and decide whether the benefit justifies the cost of preparing the return.
Another reason for filing Form 706 involves married couples whose living trusts divide into separate trusts when the first spouse dies.
These are commonly called AB or ABC trusts. Depending on how the trust was written, it may divide into a survivor's trust, a bypass trust, and sometimes a marital trust.
If there's a marital trust, it may qualify for what's called a QTIP election.
QTIP stands for Qualified Terminable Interest Property. The basic arrangement is that Mom's share of the estate goes into a trust for Dad's benefit during his lifetime, but Mom has already determined who receives whatever is left when Dad dies.
If the marital trust qualifies and the election is made on Form 706, the property can qualify for the federal estate tax marital deduction when Mom dies.
There is a trade-off. The QTIP property remaining when Dad dies is generally included in his estate for federal estate tax purposes. But that can also produce an important income tax benefit: a new step-up in basis when Dad dies.
We'll get to that below.
These elections can be complicated. Not every marital trust qualifies, and the election generally cannot be revoked. If the trust divides into separate trusts at the first spouse's death, the trustee should have the documents reviewed by an estate tax specialist before the filing deadline.
We discuss what happens to a married couple's trust after the first death in Joint Trust Administration After a Spouse Dies in California.
While Mom was alive, the income earned by her revocable living trust was reported on her personal Form 1040. When she dies, the trust ordinarily becomes a separate taxpayer for income tax purposes.
The trustee gets a new tax identification number for the trust, called an EIN, and the trust may have to file its own income tax returns.
The federal return is Form 1041. California uses Form 541.
These returns report the taxable income the trust earns during the administration: interest, dividends, rental income, and gains or losses from the sale of investments or other assets, along with allowable deductions.
A Form 1041 isn't necessarily required every year. That depends on the trust's income and other filing requirements. The CPA will make that determination.
This is probably the part of trust taxation that causes the most confusion among beneficiaries.
As a general rule, receiving an inheritance isn't taxable income. But income earned by the trust after the decedent's death is taxable to someone. Depending on the circumstances, that may be the trust or the beneficiaries.
Suppose Mom dies with $300,000 in her trust bank account. During the administration, that money earns $12,000 in interest. The trustee completes the administration and distributes the $312,000 equally among Mom's three children.
Each child receives $104,000.
Does each child have to report $104,000 as income?
No. The $300,000 that Mom left them is their inheritance. The $12,000 in interest is income earned after she died.
Assuming the interest is properly passed through to the beneficiaries under the income distribution rules, each child receives a Schedule K-1 reporting $4,000 in taxable interest.
Each beneficiary reports that $4,000 on his or her personal income tax return. The other $100,000 isn't taxable income merely because it came from Mom's trust.
That's how a Schedule K-1 works.
Of course, it gets more complicated when the trust has different kinds of income, expenses, and distributions. The CPA calculates how much income is taxable to the trust and how much passes through to the beneficiaries.
One consideration is that trusts reach the highest federal income tax brackets at much lower income levels than individuals. Consequently, there may be a tax advantage to distributing income to the beneficiaries rather than accumulating it in the trust.
But the trustee shouldn't be making distributions simply to save income taxes without considering the other obligations of the administration.
This is why it’s important that the trustee hire a CPA experienced in preparing 1041 returns.
Capital gains are treated somewhat differently.
Suppose the trustee sells investments and realizes a $30,000 capital gain. Even if the trustee distributes the sale proceeds to the beneficiaries, the gain may remain taxable to the trust.
Capital gains are generally allocated to trust principal, although there are exceptions that can allow them to pass through to beneficiaries.
Again, this is something for the CPA to determine. The fact that the trustee distributed the money doesn't necessarily mean the beneficiaries owe the tax.
Yes, and this is something that sometimes gets overlooked.
Suppose the trustee liquidates investments during the administration and realizes capital losses. The trust can use those losses to offset capital gains, subject to the tax rules.
But suppose the administration ends and the trust still has an unused capital loss carryover.
When the trust terminates, that unused loss may pass through to the beneficiaries who succeed to the trust property. The loss is reported on their final Schedules K-1, and the beneficiaries may be able to use it on their personal tax returns.
There can also be excess deductions when the trust terminates. For example, certain deductible attorney fees, CPA fees, and other administration expenses may exceed the trust's income in its final tax year.
Under the applicable rules, some of those deductions may also pass through to the beneficiaries.
The CPA has to determine which losses and deductions qualify and how they're allocated.
So a final Schedule K-1 doesn't necessarily mean the beneficiary owes additional taxes. Sometimes it provides a deduction or loss that reduces the beneficiary's taxes.
One of the biggest tax advantages of inheriting property is the step-up in basis.
Suppose Mom bought her house in 1985 for $200,000. When she dies, the house is worth $1 million.
Generally, the income tax basis of the house becomes its fair market value at Mom's death: $1 million.
If the trustee sells the house shortly afterward for $1 million, there may be little or no capital gain.
The same general rule applies to eligible stocks and other investments that Mom owned when she died.
Traditional IRAs are different. They generally don't receive a step-up in basis, and distributions remain subject to the applicable income tax rules.
California community property has an additional advantage. When one spouse dies, both halves of qualifying community property generally receive a new basis, not just the deceased spouse's half.
We discuss these rules in Selling an Inherited California Home: How Capital Gains Tax Really Works.
One thing we routinely recommend is getting a date-of-death appraisal of the real estate and obtaining date-of-death values for brokerage accounts. Those values establish the basis that the CPA will need when the assets are sold.
This is an important issue with older married couples' trusts, particularly those prepared when the federal estate tax exemption was much lower. Many of those trusts required the assets to be divided into a survivor's trust and a bypass trust when the first spouse died. The assets allocated to the bypass trust generally received a step-up in basis when the first spouse died. But the bypass trust was designed to keep those assets out of the surviving spouse's taxable estate. That usually means no second step-up when the surviving spouse dies.
Here's an example.
Dad died in 2016, and investments worth $500,000 were allocated to his bypass trust. Mom dies in 2026, and those investments are now worth $1 million. Assuming there haven't been other basis adjustments, the investments still have a $500,000 basis. If the trustee sells them for $1 million, there could be a $500,000 capital gain.
Compare that with investments held in Mom's survivor's trust. Those assets generally receive a new basis adjustment when Mom dies, assuming they're included in her estate and otherwise qualify.
So the trustee might have two brokerage accounts, each worth $1 million, with very different income tax consequences.
This is why it's important to know which trust owns the assets.
Remember the QTIP election we discussed earlier?
Unlike a typical bypass trust, the remaining assets of a properly elected QTIP trust are generally included in the surviving spouse's federal gross estate. As a result, those assets generally qualify for another basis adjustment when the surviving spouse dies.
That's potentially a significant advantage over a bypass trust, although including the assets in the surviving spouse's estate may also have estate tax consequences. The trustee should not assume that every account receives a step-up simply because Mom died.
In a typical trust administration, the house is sold, the brokerage accounts are liquidated, and all the money is sitting in the trust bank account. The beneficiaries want their inheritance, and the trustee is anxious to finish the trust administration. But there may still be tax returns to file and taxes to pay.
Before making final distributions, the trustee should talk to the CPA. Has Mom's final Form 1040 been prepared? Is Form 706 required, or should one be filed for portability or a QTIP election? Will the trust have to file Form 1041 and California Form 541? Will the beneficiaries receive Schedules K-1?
And, most importantly, how much money should the trustee keep in reserve to pay the remaining taxes and expenses?
That doesn't necessarily mean the beneficiaries have to wait until every tax return is filed before receiving any money.
In most of our administrations, we recommend making partial distributions when it's safe to do so, while retaining enough money to finish the administration.
But if the trustee distributes everything and an unexpected tax bill arrives, the trustee may have a problem. We discussed that in Can a California Successor Trustee Be Personally Liable?
The trustee doesn't have to understand all the tax rules. I certainly wouldn't expect someone administering Mom's trust for the first time to understand QTIP elections or the income distribution rules for Form 1041. But the trustee does need to recognize when professional tax advice is needed and make sure the work gets done.
That's why we recommend involving the CPA early, rather than waiting until the trustee is ready to write checks to the beneficiaries.
If you're serving as successor trustee, we can help you handle the administration and coordinate with your CPA to get the job finished.
Contact us for a free, 15-minute initial call with one of our attorneys.