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How many kinds of taxes are owed when someone dies?
Old 09-19-2007, 12:24 PM   #1
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How many kinds of taxes are owed when someone dies?

Judy has $3 million cash. Her husband is deceased. If Judy dies today, how many kinds of taxes will her only child have to pay? Will there be estate taxes, inheritance taxes(?), income taxes? Other taxes?

I find lots of discussion on the web about estate taxes. Are those the only taxes owed when someone dies and passes their stuff to their heirs? I understand there is a $2 million "exclusion" at present. I presume that means Judy's estate will pay taxes on just $1 million ($3 million - $2 million)? Will Judy's daughter also have to pay income taxes on the stuff she inherits? If so, what amount will she pay taxes on? The full $3 million, or the part left over after estate taxes are paid? I can't find a source that explains ALL the tax ramifications.

What's the deal with the $12,000 annual gift allowance? Does the person recieving the gift have to pay any taxes at all? Is this different from the $2 million exclusion?
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Consult a Tax Accountant
Old 09-19-2007, 01:10 PM   #2
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Consult a Tax Accountant

I would suggest Judy sit down with a good tax accountant and an attorney to understand what will happen to her assets and what she might want to do now to mitigate tax burden.

Note, technically heirs pay no taxes on inheritances, but Judy's estate will be responsible for estate taxes, taxes on income while in probate etc. Capital gains are stepped up on inheritance. There are many considerations that need detailed professional attention at this size estate.
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Old 09-19-2007, 01:25 PM   #3
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Final Tax Return for Judy (and any resulting taxes due).
Estate Tax Return (both Federal and State, if applicable).
The only child should be sure to "step up" the basis of any asset that it may apply to. The date of "step up" would be date of death OR within 6 months of death (check that additional period as it may have changed). Something like RE and/or stocks could benefit from the "step up" in basis.
Taxes on a $12K gift would not be due from the receiver. The giver may have to pay depending on how much of the Lifetime exemption has been used up.

Due to potential pitfalls (not to mention dealing with this subject so close to the loss of a loved one), and assuming the child is not conversant with the law(s) applicable, a GOOD attorney should be consulted - one that deals with the subject (of Probate) on a frequent basis. Sometimes (but be careful) the people down at the Courthouse that handle PROBATE can help find a good local attorney.
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Old 09-19-2007, 02:31 PM   #4
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Reading the prior posts makes me realize how difficult it is to describe the taxes that might be due on death. I'll add some information that also won't be complete because of how complicated tax law is.

1. Income taxes. A final tax return for the decedent has to be filed. This return will include all income earned by the decedent up to the date of death. With some twists, it is just like any other income tax return but based on a short year.

2. Federal and any state estate taxes. Estate taxes are the same thing as inheritance taxes. They are owed by the estate, not the heirs, and the personal representative/executor is responsible to see they are paid. It is paid on the value of all the assets of the decedent as of the date of death (or six months later, called the alternative valuation date). Valuations can get complicated and people do a variety of things to keep assets out of estates. Some are successful and some are not. Generally, assets given away with strings attached are part of the estate, such as assets held in a revocable trust. There is a three year look back for certain types of transfers, like transfers of life insurance ownership. Also, certain assets are part of the estate even if the decedent didn't really have the full ownership or the benefit of the asset. For example, if the decedent owned life insurance on her life, the amount of the insurance benefit would be part of the estate. If the decedent owned an asset in joint tenancy with someone else, if all the money for that asset came from the decedent its entire value would be part of the estate. Gifts made by the decedent where no gift tax was paid, less the yearly exclusion amounts, will be counted as part of the estate. Any gifts less than the exclusion amount are not taxed.

A spouse can inherit without any estate taxes due, but when the surviving spouse dies, estate tax is due on everything the survivor has at that point. Sometimes planning is done so that the spouse doesn't inherit everything outright, in order to maximize the use of each spouse's two million dollar exemption.

Legitimate debts of the decedent and expenses incurred in the administration of the estate are deducted from the total value to determine the value of the estate to be taxed. There is a deduction for any estate tax paid to a state. The state exclusion amount may be different than the federal amount. Through 2008, a total of $2,000,000 in assets are exempt from federal estate tax so the tax is only on the value exceeding that amount. There is an unlimited charitable deduction; inotherwords, if the decedent left everything to a qualified charity no estate tax is due.

3. Income taxes due by the estate. During the administration of the estate, the estate may earn income. There might be interest on bank accounts. There might be stock dividends. There might be rental income on real estate. Maybe stock is sold for more than it was worth on the date of the decedent's death. Income taxes will have to be paid on this income.

4. Sometimes a person dies with assets that will have an income tax due at some point in the future because no income tax was ever paid. For example, if the decedent had a 401k, when distributions are made on that 401k income taxes will have to be paid. In this case, both estate taxes and income taxes might have to be paid on the asset, but there is a partial credit in the tax code. Another example is interest due the decedent. Maybe the decedent had savings bonds that had a lot of built up interest. Income taxes on that interest has to be paid when those bonds are cashed in (or before), either by the heirs or by the estate.

Other assets get a "stepped up" basis. For example, real estate, stock, and tangible personal property. If those assets are sold by the heirs at some point in the future, the heirs only have to pay capital gains taxes on the increase in value from the valuation at the death or alternate valuation date.

Ok, I'll stop now. I at least wanted to give a flavor for the complexity of the tax issues when a person with significant assets dies.
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Old 09-19-2007, 02:31 PM   #5
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km4hr,

I would advise Judy's only child to get her information from the horse's mouth and consult the IRS publications for an introduction to the topic of estate taxes:

Publication 950 (9/2006), Introduction to Estate and Gift Taxes

I would primarily advise that because some of what RWood wrote immediately above is misleading and/or incorrect. Internet forums are not a good place to find authoritative answers on tax questions, although they are good for finding out what questions to ask or what things to consider.

My answers to your questions:

"Judy" would pay income taxes for her last partial year on this earth just like a normal living taxpayer, except there are some unique rules I think that apply. (Since Judy is dead, her personal representative would file them on her behalf. Any tax payment or refund would come from or go to her estate.)

If her estate earns any money I believe there is an estate income tax form that the personal representative would fill out as well, like dbr alludes to.

Inheritance taxes, estate taxes, and death taxes are all terms for the same thing. The IRS calls them estate taxes.

There are no additional taxes due at death other than those mentioned above AFAIK.

Yes, Judy's estate will be liable for estate taxes on the amount left over after subtracting the exclusion amount (technically it's a tax credit, but the effect is the same). Note also that the estate tax rate is rather steep. Note that the exclusion amount varies over the next several years -- it is $2M now, $3.5M in 2009, is completely gone in 2010, and reverts back to a lower amount ($1M, I think) in 2011. Note also that Congress can change the tax laws between now and then if they so choose.

Judy's daughter would not pay any taxes on the money she receives from the estate. However, she will of course be liable for any income taxes due on any subsequent dividends, rents, capital gains (with the step up), etc.

The annual gift tax exclusion of $12K you mention...Judy can give her daughter $12K per year, and the gift will be without tax consequence to either Judy or her daughter. (In fact, anyone can give anyone else up to $12K per year without tax consequence, so if Judy's only daughter is married Judy could give $12K to the daughter and $12K to the son-in-law.) If Judy gives more than that amount per year, she'd be required to file a tax return and the excess would reduce Judy's estate tax exemption amount (the $2M amount above). Note that there are exceptions to what constitutes a gift -- if Judy pays her daughter's college tuition or medical expenses those do not count.

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Old 09-19-2007, 02:42 PM   #6
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Beyond all the mechanics that everyone has outlined already, like all tax planning it is 1000 times better to do estate tax planning before death rather than after.

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Old 09-19-2007, 02:59 PM   #7
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The Feds have an estate tax that has a current exemption, as you mention, of 2M so 1M of the 3M estate would be taxed at approximately a 50% (45?) rate . In some coming year (2009?) , the exemption will increase to 3.5M so no estate tax would be due in that year.

You do not pay "income tax" on inheritances. However, states may have their own individual systems for taxing estates or inheritances so how they would tax would be very much dependent on where you live. CA effectively has neither at this time. Also if you receive distributions from inherited retirement plans or IRAs in later years, these could be taxable income.

A person can gift 12K to any other person annually w/o tax consequences to either.
If the gift exceeds 12K in any particular year, the excess subtracts from the giver's lifetime gift exemption (1M?) but there are no tax consequences for the receiver.

As others have said, this is an area full of tricky details .
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Old 09-19-2007, 07:59 PM   #8
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Thank you all for your carefully considered responses. The example given represents a real situation somewhat. I plan to discuss this with a tax attorney. But I've always felt that any prior knowledge one can attain can be a benefit in such discussions.

I realize the tax codes are tricky. One of the investing magazines puts together a somewhat typical income tax situation and sends it out to several tax preparers each year. They then report the results. The differences vary widely and are truly amazing. For that reason I wonder if it would be a good idea to present my situation to several tax attorneys and choose the one that comes out most favorable to me. That's provided they all seem to be on the level of course.
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Old 09-20-2007, 04:51 AM   #9
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Originally Posted by Martha View Post
Sometimes planning is done so that the spouse doesn't inherit everything outright, in order to maximize the use of each spouse's two million dollar exemption.
When would above apply ?

I'm new to this, have (hopefully) a long way to go before this is an issue, and I know professional advice is important.

Using current levels. My understanding is:
- If you have less than $2mil, when one spouse dies, all assets go to other spouse. When second spouse dies, asset total is below $2mil threshold, so everything's OK.

- If you have between $2 and $4mil, there's some kind of "bypass" trust that can be set up to take advantage of the $2mil once for each parent ?

- If you have over $4mil, I don't think there's any estate tax avoidance possibilities on the amount greater than $4mil - correct ?

Again this is a rough understanding. Thanks for any clarification.
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Old 09-20-2007, 10:27 AM   #10
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Quote:
Originally Posted by Delawaredave5 View Post
When would above apply ?

I'm new to this, have (hopefully) a long way to go before this is an issue, and I know professional advice is important.

Using current levels. My understanding is:
- If you have less than $2mil, when one spouse dies, all assets go to other spouse. When second spouse dies, asset total is below $2mil threshold, so everything's OK.

- If you have between $2 and $4mil, there's some kind of "bypass" trust that can be set up to take advantage of the $2mil once for each parent ?

- If you have over $4mil, I don't think there's any estate tax avoidance possibilities on the amount greater than $4mil - correct ?

Again this is a rough understanding. Thanks for any clarification.
I'm pretty sure Martha is talking about a marital bypass trust, which you also allude to in your second bullet. The way I understand it can work: the first person to die directs $2M into a trust and the remainder to the spouse. The trust is set up to where the spouse can receive the income from the trust to live on and maybe dip into principal also. When the spouse dies, the trust then gets distributed to someone else (the kids, for example). This way both $2M exemptions can get fully used.

To clarify something - when one spouse dies, their assets are distributed according to their beneficiary designations, will, trust, and possibly the intestacy laws of their state if they die without a will. It isn't necessarily true that the assets would pass to the spouse.

As to your last bullet, there are things one can do prior to death with large estates to help minimize the estate tax, but I don't think there's much you can do once a couple with $4M+ dies.

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Old 09-20-2007, 10:31 AM   #11
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Other than a gifting or transfer program so the 4 million plus doesn't keep getting bigger and bigger. Eg, a tranfer of life insurance ownership to a life insurance trust or to your children. At least the growth will be outside the estate. A charitable remainder trust is also a possibility.
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Old 09-20-2007, 10:42 AM   #12
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Meant to add about my earlier comment about RWood's reply:

My main point is that one should not rely on what we say (even though it's mostly correct) and should check with trusted professionals who are familiar with your individual situation and the applicable laws in your state or area or other authoritative sources. RWood made this point in his post better than I could.

It sounds like the OP understands this, though.

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Old 09-20-2007, 10:47 AM   #13
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To add on to what Martha said, gifting to 529 plans for children and grandchildren is also a possibility. In at least some 529 plans, you can gift up to 5 years worth of the gift amount per recipient and that money is then out of the estate. Also, as mentioned previously, there is a provision where paying for college or medical expenses directly do not count against the annual gift limit. From an IRS web page on the Gift Tax:

"The general rule is that any gift is a taxable gift. However, there are many exceptions to this rule. Generally, the following gifts are not taxable gifts.
  • Gifts that are not more than the annual exclusion for the calendar year.
  • Tuition or medical expenses you pay for someone (the educational and medical exclusions).
  • Gifts to your spouse.
  • Gifts to a political organization for its use.
  • Gifts to qualified charities (a deduction is available for these amounts)."
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Old 09-20-2007, 09:24 PM   #14
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Don't forget that it takes time to settle an estate. The income (interest, dividends, realized capital gains) generated by the estate will show up on the estate tax return, but will often be passed onto the heirs who will get a K-1 for that income. That way, the heirs will get taxed in their income tax brackets.

Example, date of death, all the XOM shares are valued at $80 a share are sold for $90 a share a few months after the death and the cash distributed to heirs. The heirs pay LTCG tax on the $10 gain. Etc.

Example: Joint account with parent is automatically transferred to surviving account holder, but STILL INCLUDED IN THE ESTATE, since the parent contributed all funds to the account. Estate taxes may need to be paid on the amount. Interest earned on the account after date of death might need to be divided among all heirs as well. "Nominee distribution for estate of ...." may end up in several places on your tax return.
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