TAXES AT DEATH: WHO PAYS THEM?Death and taxes are commonly referred to as the two things that one cannot avoid. Federal and state estate taxes merge these two great inevitables. The question is, "Who has to pay estate tax?"
In discussing taxes related to someone's death, there are four relevant taxes: income tax, estate tax, gift tax and the generation skipping transfer tax. Each of these taxes and ways to minimize them will be discussed in more detail in future articles.
First, I want to share the good news. Pursuant to an express provision within the Internal Revenue Code, property received by inheritance is generally not subject to income tax. This means that when one receives property from a deceased relative or loved one, the recipient of the property does not have to declare it as income. The exception to this rule pertains to property received as an inheritance that would have been taxed if the decedent had received it. This is called, "Income in Respect of the Decedent." Income in respect of the decedent relates to, among other things, unpaid salary or commissions, unrealized income from the sale of assets, and individual retirement accounts (IRA) or qualified retirement plan distributions. Because these items of income would have been taxed when the decedent received the income, the recipient must pay the income tax when the assets are received as an inheritance.
Now, I will share the bad news. Although inherited assets are generally not subject to income tax, the assets may be subject to estate tax. In 2000, one can leave as an inheritance $675,000 to whomever one wishes without incurring an estate tax. In 1997, Congress passed new legislation that incrementally raised the estate tax level from the previous $600,000 level. By the year 2006, the amount will be $1,000,000 per person. Presently, however, after $675,000, the federal government taxes the estate at 37% and the estate tax rate increases until it reaches 55% for all assets above $3,000,000.
It should be noted that the taxable estate includes all of an individual's assets, some of which most individuals would not consider as part of their estate. In determining whether one has an estate tax concern, the following are some of the assets to consider: life insurance policies in which one owns or has an incident of ownership, retirement accounts, annuities, real estate, personal property, the entire value of jointly owned property if the other joint owner(s) are not a spouse and did not contribute to the purchase price, interests in property that was sold but in which the seller retained a life estate (i.e., the right to use the property after the sale), business interests, and other additional assets and taxable interests in property. If the value of the assets exceeds $675,000 there is an estate tax concern.
Significantly, many married couples mistakenly believe that they do not have an estate tax concern unless their combined assets exceed $1,300,000 (that is $675,000 for each spouse). This assumption is wrong. Professionals who unknowingly further this mistaken belief are wrong. Married couples who want to leave their assets to each other upon the first spouse's death and then to their children or other loved ones upon the second spouse's death, must engage in somewhat sophisticated estate planning to transfer the full $1,350,000 to their children or other loved ones without incurring an estate tax. Couples who have not done estate planning and have not established a special kind of trust (credit shelter trust, by-pass trust, A/B trust, QTIP trust are some of the commonly used names) either within their will or within their revocable living trust will likely not be able to pass the $1,350,000 in 2000 without estate tax.
Another mistaken belief relates to avoiding probate in order to avoid estate tax. Avoiding probate and avoiding estate tax are two separate things. A basic revocable trust that is properly funded (i.e., assets have been properly transferred into the name of the trust) will avoid probate. However, such a trust will do nothing to avoid or lessen estate tax. Probate is an administrative proceeding that is needed to transfer assets when one dies with the assets in his sole name. Estate tax is a federal and state tax imposed on all assets that one owns or has certain beneficial interests that exceed $675,000 in 2000.
The federal gift tax and generation skipping taxes are companions to the estate tax. As a means to prevent people from gifting away their assets shortly before their death in order to avoid the estate tax, the government imposes a gift tax on the transfer of all assets in excess of $10,000 per year, per person. Additionally, the estate tax is designed to tax an individual's estate each time it passes to a subsequent generation. A generation skipping tax of 55% is imposed when an individual conveys property to loved ones below the first generation (that would include distributions to grandchildren, great grandchildren or non family members more than 37.5 years younger than the decedent). Fortunately, the tax does not apply to most individuals because each of us can leave up to $1,000,000 to beneficiaries more than one generation below us without incurring a generation skipping tax. Only those individuals with very large estates or those who wish to leave large inheritances to a grandchild or young, unrelated beneficiary need to be concerned with this tax.
This is a brief summary of the taxes pertaining to transfers of property at death. Future articles in this column will discuss techniques to avoid and minimize these taxes.
Jeffery J. McKenna
Attorney licensed and servicing
clients in Utah, Nevada and Arizona
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