When it comes to estate planning, it is wise to have a good understanding of the main types of taxes your estate may be exposed to, and how to best plan to minimize your estate’s tax liability. The same strategy applies to those who expect to receive a large share of a loved one’s inheritance at some point in the future. Dealing with taxation matters when someone passes away can be stressful and overwhelming, so it is best to do your homework early so you can be prepared. Our estate planning law firm helps countless clients by customizing their estate planning strategies to reduce or avoid certain types of taxes — here are a few essential tips for anyone looking to do the same.
What is the Estate Tax ?
The IRS defines the estate tax as a “tax on your right to transfer property at your death”, and it consists of an “accounting of everything you own or have certain interests in at the date of death.” For 2021, the highest estate tax rate is 40%, but only estates valued at or above $11.70 million are required to pay federal estate taxes. It is important to point out that taxes are assessed only on the value of the estate that exceeds the 11.70 million threshold, meaning most estates in this country are unlikely to have to pay federal estate taxes. However, many states have their own estate taxation structure, so check the laws in your state residence, as well as each state in which you own real estate or personal property to see if you are required to pay state estate taxes.
Many of our clients must plan around Massachusetts estate taxes, even the clients who are residents of other states, like Florida. The estate of a Massachusetts resident is subject to the state estate tax if the total of the assets owned at death exceeds $1,000,000. While the tax rate is graduated, a quick rule of thumb to estimate the amount of estate tax liability is:
(Estimated estate value – $1,000,000) x 10% = estimated MA estate tax
Although the above equation is not precise it gives a reasonable estimate. For example, lets look at a single person who passes with an estate of $2,000,000. The decedent has an exemption of $1,000,000, leaving $1,000,000 subject to the tax. At 10% the tax would be estimated at $100,000. The actual tax is $99,600.
Residents of states other than Massachusetts may still face Massachusetts estate tax if they own Massachusetts real estate or own personal property located in Massachusetts. For example, a Florida resident who owns a summer home on Cape Cod will be subject to the Massachusetts estate tax. Let’s assume the Florida resident has an estate of $1,500,000 with Massachusetts real estate valued at $750,000. To estimate the tax of an out of state resident we need to calculate the following:
(Total Estate Size – $1,000,000)
MA Estate Tax on a MA Resident
MA Estate Tax on a MA Resident
x ((MA Real Estate Value + MA Personal Property Value)/Total Estate Size)
MA Estate Tax on Out of State Resident
So for the example of the Florida resident with an estate size of $1,500,000 and MA Real estate worth $750,000 the tax estimate is as follows:
($1,500,000 – $1,000,000) x 10% = $50,000
$50,000 x ($750,000/$1,500,000) = $25,000
So we can see that the estimated MA estate tax for our Florida resident is $25,000. In actuality, the MA Estate Tax on the estate of a Florida resident in this example would be $32,200.
It is important to recognize that every person with assets located in states other than their state of residence must be sure that his or her estate plan considers the tax requirements not only of his/her state of residence, but also the tax laws of any state in which assets are owned – it doesn’t matter whether the asset owned is a second home, a time share or property co-owned with a friend or a sibling.
What is the Gift Tax?
The gift tax is defined as a tax on the transfer of property from one individual to another. This transfer results in the donor receiving nothing in return, or receiving a return that is less than the full value of what was transferred. Many property transfers may be counted as gifts, including money, assets, use of income generated by a property, and even a low-interest or interest-free loan. Many people are aware that there is an annual gift tax exclusion of $15,000. In other words, each person may give up to $15,000 to any other person. As of 2021, any person may make many gifts of up to $15,000, as long as no more than $15,000 is given to the same person. Any gift in excess of the annual exclusion will reduce the lifetime exemption. The IRS requires every taxpayer to file a tax return (Form 709) by April 15 of the following year to report gifts in excess of $15,000.
The code allows each person an amount they may give during one’s lifetime without having to pay a transfer tax. As of 2021 the lifetime gift tax exemption is $11.70 million – the same amount as the estate tax exemption. This means an individual can make gifts during their lifetime of up to 11.70 million without being subject to the gift tax. Anytime that a taxpayer makes a reportable gift (ie. over $15,000) the lifetime exemption is reduced as is the estate tax exemption.
How does the ordinary income tax and capital gains tax apply to my estate or my trust?
Certain assets in an estate may be subject to income tax. For example, if a decedent owned assets that generated income, such as rental properties, CDs, stocks, bonds, mutual funds, or savings accounts, and those assets generated more than $600 in income, then it will be necessary to file an estate income tax return. Similarly, if the decedent created a revocable trust, once the person who created the trust has passed away, the trust becomes irrevocable and it, too, will need to file an annual income tax return. Once these assets are transferred to an heir, that person will not need to pay income tax on the amount received, but any subsequent earnings generated by the inherited assets will be subject to income tax and must be included in that person’s yearly tax return.
Likewise, heirs may need to pay capital gains tax if selling any inherited property that may have appreciated in value. The capital gains tax is a tax that applies to the growth in value of investments at the time those assets are sold. For example, if someone inherits a house worth $200,000.00 and later sells it for $250,000.00, that person will need to pay capital gains tax on the $50,000.00 difference.
How does the Generation-Skipping Transfer tax work?
The Generation-Skipping Transfer Tax (or GSST) is a tax applicable to transfers of property (through gift or by inheritance) to a beneficiary who is at least 37 ½ years younger than the donor. It was designed as a way to stop donors from transferring large sums to their grandchildren without paying any taxes. The GSST has the same exemption threshold as the Estate and Gift taxes – 11.70 million. Any transfers above that threshold will likely be subject to the flat GSST rate of 40%, which leaves the vast majority of the estates in the country exempt from paying GSST.
Are there other taxes I need to keep in mind for my estate plans?
Yes, there are four other types of taxes you may want to know about. Not every estate will be subject to all of these taxes, but it is important to have an understanding of what they are and whether they may apply to your estate.
- Net Investment Income Tax: a 3.8% surtax applicable to income earned from investments. Only the income that lies above the thresholds outlined by the IRS will be required to pay net investment income tax. Estates and most trusts are subject to this tax if the income of the estate or trust exceeds a very low threshold (as of 2021 the threshold is only $13,100). With proper planning this tax may often be eliminated.
- State and Local taxes: As of 2021, 13 states in the U.S. levy estate taxes. When planning your estate, check if your state and local government require payment of any estate or inheritance taxes. Additionally, estates and trusts are subject to state income taxes – and sometimes there may be income tax liability in multiple states.
- Business Income tax: if an estate includes assets (such as rental properties or a family business), it may be required to pay business income tax.
- Payroll tax: in the case of a decedent that was employed and receiving paychecks, the final paycheck may or may not be subject to payroll taxes depending on whether it is issued in the same year or the following year following the death. Sometimes the estate or trust may have to pay payroll taxes too. For example, if the client has employed caretakers or home health workers, then payroll taxes will need to be paid.
As you can see, taxation rules pertaining to estates can be quite confusing. At Boyd & Boyd, P.C. our attorneys can help you understand these complexities and give you advice so you can employ the best strategies to reduce the amount of tax to which your estate may be subject. Contact us today for a free strategy session.