Overview of Taxes that Affect an Estate
Gift Taxes, Estate Taxes, Inheritance Taxes, GST Taxes, Income Taxes
NOTE: Tax laws change and the following information may not reflect recent changes in these laws. For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
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.
The gift tax is probably the most ignored tax that can affect an estate. Currently, the federal tax code exempts up to $14,000 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 $14,000 in any given year to the same person, you'll be making a taxable gift and you'll incur a gift tax. However, instead of paying the tax immediately, currently, the federal tax code gives you a lifetime gift tax exemption of $5,340,000 that can be used to offset your taxable gifts.
Think of the gift tax exemption as a "$5,340,000 coupon" against the application of the gift tax.
For example, let's assume that this year you decide to gift $114,000 to your son for a down payment on a house. For gift tax purposes, the first $14,000 will have no consequence, but the next $100,000 will be considered a taxable gift. Thus, once the gift is made, instead of having a $5,340,000 gift tax coupon, you'll have a $5,240,000 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 must be filed on April 15 of the year following the year in which the gift was made.
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, and Tennessee abolished its gift tax as of January 1, 2012. Minnesota enacted a gift tax in 2013 but then repealed it retroactively.
Estate Taxes - Federal Estate Taxes and State Estate Taxes
For decedents who die during 2014, the federal estate tax applies to estates that are valued at more than $5,340,000, 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 January 1, 2014, the District of Columbia and the following states impose a separate state estate tax: Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Tennessee, Vermont, and Washington. Note that Tennessee's estate tax was scheduled to be phased out by January 1, 2016.
State Inheritance Taxes
As of January 1, 2014, 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 - Iowa, Kentucky, Maryland and New Jersey - assets passing to the deceased person's descendants are also exempt. Note that currently Maryland and New Jersey are the only two states that assess 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 if 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 after 2014, the generation skipping transfer tax (GST) applies to transfers of more than $5,340,000 that “skip” one or more generations. “Skip” 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 ½ years younger than you. Current law provides that the GST exemption will be indexed for inflation in future years.
The majority of the 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 if your state has its own generation skipping tax.
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 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.