You'll need a basic understanding of the different types of taxes that can affect your estate when you're preparing or updating your estate plan. They include 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. The federal tax code exempts up to $15,000 per year in gifts per person per year as of 2021. This is referred to as the annual exclusion from gift taxes, and it increases to $16,000 per person in 2022 because it's adjusted periodically to keep pace with inflation.
You'll make a taxable gift when you give over $15,000 or $16,000 to the same person in that given year, and you'll incur a gift tax. But instead of paying the tax immediately, the federal tax code also gives you an option to offset your taxable gifts: a lifetime gift tax exemption. It's $11.7 million if you die in 2021, and this increases to $12.06 million in 2022 because it also adjusts for inflation. You can use this exemption to cover your taxable gifts over the annual exclusion amount.
Note
Think of the lifetime gift tax exemption as a $12.06 million coupon against the application of the gift tax.
Let's assume that you decide to give your son $115,000 for a down payment on a house in 2022. The first $16,000 will have no consequence for gift tax purposes, but the next $99,000 is considered a taxable gift. Instead of having a $12,060,000 gift tax coupon, you'll have an $11,961,000 coupon remaining after the gift is made and the balance is applied to the lifetime exemption.
Taxable gifts made during the course of the year must be reported on IRS Form 709, the United States Gift (and Generation-Skipping Transfer) Tax Return. The return must generally be filed by April 15 of the year following the year in which the gift was made.
Note
Those affected by winter storms in Texas, Louisiana, and Oklahoma in 2021 were able to delay filing tax returns and paying taxes until June 15. This applies to both businesses and individuals, and it covers taxes that otherwise would have been due before June 15, including any gift taxes due on Tax Day.
State Gift Taxes
Connecticut imposes itsown gift taxes in addition to the federal gift tax. 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 Tennessee abolished its gift tax as of January 1, 2012.Minnesota enacted a gift tax in 2013, but then it repealed it retroactively.
State Estate Taxes
The District of Columbia and the following states impose a separate state estate tax as of tax year 2021: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.
State Inheritance Taxes
There are six states that collect a separate inheritance tax as of 2021. This tax is imposed on certain beneficiaries who receive a deceased person's property. The states are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Assets passing to the deceased person's surviving spouse and charity are exempt from the inheritance tax in all these states. Several of them also exempt assets passing to the deceased person's descendants. Maryland is the only state that assesses both state estate taxes and state inheritance taxes.
State laws change frequently, so consult with a qualified estate planning attorney in your location to determine whether your assets will be subject to a state estate tax or a state inheritance tax after you die. There may be an estate tax or an inheritance tax due on your out-of-state property after your death as well 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.
Generation-Skipping Transfer Taxes
The generation-skipping transfer tax (GST) applies to transfers of more than $11,700,000 in 2021 that “skip” one or more generations. This also increases to transfers of $12,060,000 in 2022.
“Skipping” refers to 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 37½ years younger than you.
Some states that still impose their own separate state estate tax also assess a separate generation-skipping tax. It's 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
A decedent's heirs had the choice of subjecting the estate to federal estate taxes or applying the modified carryover basis regime for deaths that occurred in 2010.
Beneficiaries received the lesser of the fair market value of the property or the decedent's original basis using the modified carryover basis, instead of receiving assets with a full step up in basis to the date-of-death fair market value. This value 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.
The estate or trust assets would undoubtedly earn interest until they can be distributed out of the estate or trust to the ultimate beneficiaries for deaths occurring in any other year. The sale could result in a capital gain if certain types of assets were sold, such as stocks and bonds, even after taking into consideration the step up in basis.
Note
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 gift, estate, inheritance, or generation-skipping transfer taxes, the majority will be affected in some way 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. The estate or trust may also need to file a state income tax return for estates and trusts.
NOTE: The information contained in this article is not tax or legal advice, and it 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 changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.
