When someone dies, they leave behind all of their worldly goods. This is their estate. In some cases, the value of this estate is high enough that before the assets can be distributed to the beneficiaries of the will, or the beneficiaries at law if there is no will, estate taxes must be paid to the federal government and (depending on the state) to the state government. This is sometimes called a death tax. It is a tax on the ability to transfer property after death.
In calculating the estate’s value, the includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets. The fair market value of the items is used, not necessarily what was paid for them or their values at the time they were acquired. The total of all of these items is the “Gross Estate.”
After calculating the Gross Estate, certain deductions are allowed in arriving at the “Taxable Estate.” These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses, and property that passes to qualified charities. Once the Taxable Estate is determined, taxes can be levied.
Estate taxes are not imposed on every estate. They only affect a small portion of the country, namely those quite wealthy. For 2023, the federal estate tax applies only to people whose estate totals more than $12,920,000. The mechanism is this: the first $12.92 million is not taxed. Instead, the estate is taxed on everything over $12,920,000. That is doubled for a married couple so that they will pay no taxes on the first approximately $26 million.
When the tax has to be paid, the tax rate is usually something around 40%. This is a significant amount – a markedly large portion of the estate. On top of that, some states also impose estate taxes. Between federal and the state taxes, a lot of the estate can disappear.
How Does the Tax Get Paid?
When a person creates a last will and testament, they name a personal representative, an executor. Upon the death of the testator, the job of the executor is to execute the will and make sure that the estate is handled per the decedent’s last wishes, as well as per any applicable laws.
In cases of larger estates, the executor will have to submit the will to the local probate court. If the estate is large enough to qualify for the estate tax, the executor will most definitely have to put the will through probate. Probate may be used to determine the legal validity of the decedent’s will if there is any question or to correctly distribute the estate’s assets to any beneficiaries named in the will. It is also used to establish a plan for paying off any outstanding taxes or debts owed by the decedent’s estate.
Under the direction of the probate court, the executor will identify all assets and pay any outstanding debts, including the estate taxes. One of the executor’s tasks is to sell off any property if there is insufficient cash to pay the estate tax. Once payments from the estate have been made, the executor distributes the remaining assets to the will’s beneficiaries. Probate is a lengthy process – it can often take a couple of years to get through probate to the point where the gifts can be made.
(Note: if a person dies without a will (“intestate”), the court appoints a personal representative to carry out the same process of closing out a person’s estate upon their death. This person is known as the administrator.)
The executor is responsible for submitting payments for the taxes to the Internal Revenue Service and any state tax authorities (when applicable) in a timely fashion. The federal government requires estate taxes to be paid within nine months of the individual’s death. A six-month extension may be granted for filing the documentation, but the nine-month payment deadline for paying the actual tax is quite strict. States may vary the estate tax payment timeframe, but several follow the federal government’s rules.
Note that the IRS requires that estate taxes be paid while the estate is still in probate, not at the end of the probate process. This can be difficult because, at the nine-month mark, the executor may not have finished gathering the assets and paying other bills. If it turns out that the amount of the estate tax paid was incorrect, the executor must file an amended tax form.
One further note: a few states impose an “inheritance tax” instead of an estate tax, and one state imposes both. Heirs pay inheritance taxes upon receiving the inherited assets. An estate tax, on the other hand, is a tax levied on the entire taxable estate itself.
Inheritance tax rates may depend on the heir’s relationship to the deceased. A surviving spouse is usually exempt from state inheritance tax. Some states tax a deceased person’s children but at a low rate. More distant relatives or heirs unrelated to the deceased face the highest inheritance tax rates.
How Can I Reduce the Estate Tax?
Most people want to set up their estates to minimize the amount of tax that will have to be paid after their death. There are several ways of structuring the assets to try to reduce the amount of taxes that will have to be paid.
The first one, and the one most often used, is to transfer all or a large part of the assets to a surviving spouse. Transfers between spouses have an unlimited marital deduction, meaning they do not count in valuing the estate. They transfer from one spouse to the other without any estate tax.
Other possible ways to reduce the estate tax include:
- Donate to a charity or charities: The amount donated can typically be deducted and thus will reduce the amount of the estate while benefiting a worthy cause.
- Make gifts to family and or friends while still alive: This will reduce the size of the estate and thus reduce the tax, but keep in mind some states have a gift tax.
- Spend the money and enjoy the earnings. It is not necessary to spend all of it – just enough to lower the estate to something less than about $12 million.
- Move money into a trust account. Properly created irrevocable trusts can provide a way to legally shelter some of the assets from state and federal estate tax. An irrevocable trust is a trust the creator (the “grantor”) cannot change or revoke. Creators give up control of the assets they put into irrevocable trusts. Essentially, the creator of the trust gives away the asset, meaning it would not be right to include it in the creator’s estate.
Should I Speak to a Wills and Estate Attorney?
It is always a good idea to plan when it comes to your estate. A will is a vital part of an estate plan that brings peace of mind and affords financial security to those you leave behind. If you have questions regarding creating or updating a will and how you are affected by the estate tax, speak with an experienced estate attorney today.
The tax laws that apply to estates can be overwhelming and burdensome. Proper estate planning is essential to lessen the effects of the estate tax. A knowledgeable attorney will be able to assist you in crafting your estate plan and provide you with the best options tailored to the specific needs of your estate. In particular, an estate attorney can structure your assets and liabilities to reduce the amount of state or federal estate taxes that must be paid.
