Final 1041 for estate and estate is receiving a credit from Lawyer due to unspent money in the iolta trust

[Matilda]

I'm pretty sure I know the answer but I want to be sure.

When I hired a lawyer for the estate I had to pay money into an IOLTA trust.  All legal fees were then deducted from this initial deposit.  I only spent 1/2 of the money.  The lawyer is going to close the trust and distribute the remaining money to the heirs.

I deducted the entire amount on the 1041 the tax year I paid it .  Deduct it when you write the check was the rule.  Now that I did not use the entire amount for legal fees do I have to put a negative amount for legal fees in the final return?  I assume I do but need to verify.

Thank You

[Critter-3]

You cannot have a negative expense instead since you deducted it in the past against the estate income you must enter it back as income.  Since the deposit was made to a trust account and not directly to the attorney you should NOT have deducted the amount paid into the IOLTA trust since the attorney did not earn the fee and it was still in the trust's control.  

[Matilda]

Deducting it at the time did not seem right to me.  But I had an accountant helping me at the time and he said to include the entire deposit in that years taxes but make sure not to deduct any legal fees on future taxes until the trust is used up.  I guess he did not expect the trust to not be used up.

I was so looking forward to being done. -this really complicates things.  The tax year ended 5/31/22 and there was no more income expected as this was to be the final 1041. Executor fee has been paid, all final fees paid, all distributions done.  Now there is additional income of well over $600.00 (so a 1041 has to be filed) and also distributions of that income in the next tax year.  So - The return I thought was final is no longer final and I have to submit a short return for one month including only the iolta refund.  Is that correct?  

Thank You for the assistance.  

[Critter-3]

Yep. 

[Matilda]

I have another idea.  I would feel better if I fixed my error by amending the incorrect 1041 to include actual charged expenses for the year.  There were no distributions that year so no K1 forms are affected.  The estate got a refund and amending the tax return makes the refund smaller so I will have to send a check to the IRS.  I have no money in the estate bank account but I can pay the tax from my  bank account.   Then I can still include the actual charged expenses in the final year  because I have not submitted the final 1041 yet.  So My final 1041 remains the final one because there is no additional income.

[Critter-3]

That is also an option. 

[Anonymous_]

I agree with @Critter-3, except why not simply include the additional income in the final year return (since you indicated that return has not yet been filed)?

[Matilda]

2 thoughts on this:

-I like to do things correct, and amending the incorrect tax form will fix the error.  While putting the income back later does compensate for the error it does not actually fix it because the legal expenses should have been deducted the year they occurred and deducting in a different year can have a different effect on taxes.

I also was thinking that the IOLTA balance would have to be refunded as income to the estate bank account  so would be counted as estate income in the next fiscal tax year.  But is that how it would work?  Or are the remaining IOLTA funds already in the estate so they are not income -  they are just sitting there as if they were in an estate bank account needing to be distributed.  I know I can distribute after the end of the tax year via the 65 day rule. 

I don't know - you guys are the experts.  Would it satisfy the IRS to just include the income in the final return? it feels more like a band aid.  I don't want to have questions down the road - BUT - it would be easier as long as the IOLTA funds are not treated as income.  I do not want any income after 5/31/22.

[Anonymous_]

I believe the issue would be whether the balance that was refunded had been deducted in a previous tax year. 

If so, the refund would be considered income to the estate.

[Matilda]

That is my concern.  I'm not sure when  the refund is actually coming in the process. If the estate has income over $600 in the next tax year, it is my understanding that I will have to complete another 1041.  The trust has not been refunded yet and we are in the next tax year and the amount is well over $600.  That is the reason I thought of correcting the mistake while I still can by amending the return where I unfortunately deducted the entire amount I put in the trust that year.  This way the IOLTA refund is no longer income because it will not have been used as a deduction. 

I am not an accountant - I am just thinking this through logically with what I know.  But if there is something missing in my thought process, I can potentially make this worse.  So - I ask the experts on here - am I missing something in my thought process? 

Thank you.

Thank you for the assistance.

[Anonymous_]

Based upon what you have set forth here, amending might be the better approach.