Overview of Taxes That Affect an Estate

Gift Taxes, Estate Taxes, Inheritance Taxes, GST Taxes, and Income Taxes

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When preparing or updating your estate plan, you will need to have a basic understanding of the different types of taxes that can affect your estate: gift taxes, estate taxes, inheritance taxes, generation-skipping transfer (or GST) taxes, and income taxes.

Gift Taxes

The gift tax is probably the most ignored tax that can affect an estate. Currently, the federal tax code exempts up to $15,000 per year in gifts made by any individual to any number of other individuals. This is referred to as the annual exclusion from gift taxes. Once you make a gift over $15,000 to the same person in any given year, you'll be making a taxable gift, and you'll incur gift tax. However, instead of paying the tax immediately, the 2021 federal tax code gives you a lifetime gift tax exemption of $11,700,000 that can be used to offset your taxable gifts. Think of the gift tax exemption as a "$11,700,000 coupon" against the application of the gift tax.

For example, let's assume that this year you decide to gift $115,000 to your son for a down payment on a house. For gift tax purposes, the first $15,000 will have no consequence, but the next $100,000 will be considered a taxable gift. Thus, once the gift is made, instead of having an $11,700,000 gift tax coupon, you'll have an $11,600,000 coupon remaining.

Taxable gifts made during the course of the year need to be reported on IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, which generally must be filed on April 15 of the year following the year in which the gift was made.

In 2021, those affected by winter storms in Texas, Louisiana, and Oklahoma may delay filing tax returns and paying taxes until June 15. This applies to businesses and individuals, and it covers taxes that otherwise would be due before June 15, including any gift taxes due on Tax Day.

One state currently imposes its own gift taxes in addition to the federal gift tax: Connecticut. Louisiana abolished its gift tax as of July 1, 2008. North Carolina abolished its gift tax as of January 1, 2009. Tennessee abolished its gift tax as of January 1, 2012. Minnesota enacted a gift tax in 2013 but then repealed it retroactively.

Federal and State Estate Taxes

For decedents who died in 2021, the federal estate tax applies to estates that are valued at more than $11,700,000, which is referred to as the federal estate tax exemption. Current law provides that the federal estate tax exemption will continue to be indexed for inflation in future years.

As of the tax year 2020, the District of Columbia and the following states impose a separate state estate tax: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.

State Inheritance Taxes

As of the tax year 2020, there are six states that collect a separate inheritance tax, which is a state tax imposed on certain beneficiaries who receive a deceased person's property: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

In all of these states, assets passing to the deceased person's surviving spouse and charity are exempt from the inheritance tax, while in several of these states assets passing to the deceased person's descendants are also exempt. Note that currently, Maryland is the only state that assesses both state estate taxes and state inheritance taxes.

For more information about state inheritance taxes, refer to the State Inheritance Tax Chart.

State laws change frequently, so it is best to consult with a qualified estate planning attorney in your state to determine whether your assets will be subject to a state estate tax or a state inheritance tax after you die. Also, if you own personal effects or real estate outside of your home state, and the other state has an estate tax or an inheritance tax, then there may be an estate tax or an inheritance tax due on your out-of-state property after your death.

Generation-Skipping Transfer Taxes

For decedents dying in 2021, the generation-skipping transfer tax (GST) applies to transfers of more than $11,700,000 that “skip” one or more generations. “Skipping” refers to either a transfer that is made to a relative who is two or more generations below your generation (for example, a grandparent to a grandchild) or to a non-relative who is more than 37 1/2 years younger than you. Current law provides that the GST exemption will be indexed for inflation in future years.

Some states that still impose their own separate state estate tax also assess a separate generation-skipping tax. However, as with state estate taxes and inheritance taxes, it is best to consult with a qualified estate planning attorney in your home state to determine whether your state has its own generation-skipping tax.

Income Taxes

For deaths that occurred in 2010, the decedent's heirs had the choice of subjecting the estate to federal estate taxes or applying the modified carryover basis regime. What modified carryover basis means is that instead of the beneficiaries of an estate or trust receiving an asset with a full step-up in basis to the date-of-death fair market value, the beneficiaries received the lesser of the fair market value of the property or the decedent's original basis, which could be adjusted following specific basis-adjustment rules. Depending on the modified carryover basis of an asset, the beneficiaries could owe capital gains taxes when the inherited asset is later sold.

For deaths occurring in any year, during the course of settling an estate or trust after someone dies, the estate or trust assets will undoubtedly earn interest until they can be distributed out of the estate or trust to the ultimate beneficiaries, and if certain types of assets are sold (such as stocks and bonds), the sale may result in a capital gain, even after taking into consideration the step-up in basis. Aside from this, certain types of accounts have built-in income tax consequences referred to as "income in respect of a decedent" (or IRD) when the owner dies, such as non-Roth IRAs, 401(k)s, and annuities. Thus, while many estates and trusts may not be affected at all by gift, estate, inheritance, or generation-skipping transfer taxes, the majority will be affected in some way or another by income taxes. Income earned by an estate or trust is reported on IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, for federal income tax purposes, and the estate or trust may also need to file a state income tax return for estates and trusts.

The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.