When someone dies, taxes may not be the first thing on the minds of the loved ones left behind. Unfortunately, at some point, the heirs of the deceased person's estate or the beneficiaries of the deceased person's trust need to address taxes due as the result of their loved one's death.
Here are taxes that the estate or trust of a deceased person may owe and the types of tax returns that will need to be filed.
Federal Estate Taxes
While estate taxes seem to get all the publicity when it comes to taxes owed after someone dies, the reality is that the majority of estates will not owe any federal estate taxes.
For the 2021 tax year, the federal estate tax exemption was $11.70 million, and in the 2022 tax year, it's $12.06 million.
Estates valued at $11.70 million or more must file a federal estate tax return in 2022 using IRS Form 706. This is officially called the United States Estate (and Generation-Skipping Transfer) Tax Return.
Estates of nonresident alien decedents that owe U.S. federal estate taxes must file IRS Form 706-NA, which is officially called the United States Estate (and Generation-Skipping Transfer) Tax Return Estate of nonresident not a citizen of the United States.
State Estate Taxes
- While most estates will not have to file a federal estate tax return or pay any federal estate taxes, the residents of the following states, or a deceased person who owns real estate in one of these states, may owe state estate taxes:
State Inheritance Taxes
While an estate tax is a tax that is based on the overall value of the deceased person's estate, an inheritance tax is based on who receives the deceased person's property. Currently, only six states collect a state inheritance tax:
- New Jersey
Maryland and New Jersey collect both state estate taxes and inheritance taxes.
In all six states, assets passing to the deceased person's surviving spouse and to charity are exempt from the state inheritance tax. In Iowa, Kentucky, Maryland, and New Jersey assets passing to the deceased person's descendants are also exempt. Thus, the likelihood of an inheritance being subject to a state inheritance tax is minimal.
One type of tax that is often overlooked is the federal gift tax. There is one state that also collects a gift tax at the state level: Connecticut. In general, if an estate is subject to federal estate taxes or state estate tax in Connecticut, then the estate may have to file a gift tax return in order to report any gifts that were made during the deceased person's lifetime that were not reported while the person was still alive.
The federal gift tax return is filed using IRS Form 709, officially known as the United States Gift (and Generation-Skipping Transfer) Tax Return.
Generation Skipping Transfer Taxes
At the federal level, generation-skipping transfer taxes, or "GST taxes," only apply to estates that owe federal estate taxes where some of the estate is passing to someone who is a "skip person" or some of the estate is passing into a generation-skipping trust. A "skip person" is a relative who is two or more generations younger than the deceased person, or an unrelated person who is 37 1/2 years or more younger than the deceased person.
At the federal level, the generation-skipping transfer tax exemption is the same as the estate tax exemption, which means the exemption is $11.70 million in 2021 and $12.06 million in 2022. Thus, the majority of estates will not be subject to federal generation-skipping transfer taxes. The generation-skipping transfer tax exemption can be allocated to lifetime transfers using IRS Form 709, or after death using IRS Form 706.
The majority of the states that still collect their own separate state estate tax also assess a separate generation-skipping transfer tax.
Aside from filing a deceased person's final income tax return at the federal level (and state-level, if required), the estate may also continue to earn income on investments or property while it is being settled, and an income tax return will need to be filed (and taxes paid) on those amounts.
While certain types of assets owned by a deceased person will receive a step-up in basis, if these assets (such as stocks and bonds) are sold after death, then 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.
While many estates and trusts may not be affected at all by estate taxes, inheritance taxes, gift taxes, or generation-skipping transfer taxes, the majority will be affected in some way or another by income taxes.
Income earned by an estate or a trust is reported on IRS Form 1041, officially known as the 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.
Frequently Asked Questions (FAQs)
What if you are unsure about the tax status of an estate or trust?
If you are not sure whether what you have inherited will be subject to taxes, consult with an estate planning attorney, tax attorney, or accountant to be sure.
Who must file an estate's income tax return?
The estate's executor or personal representative is responsible for filing the income tax return and paying any estate taxes owed.