Do I need to file an estate tax return? The surprising answer

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Paul Sundin, CPA

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When a loved one dies, the IRS still wants their portion of what the deceased would owe in taxes. Most deceased people have a final income tax return, but not everyone must file an estate tax return. An estate is a separate entity from the person and it may have different tax consequences too.

Only the ‘wealthy’ must pay estate taxes at the federal level. On average 0.1% of the population pays estate tax, but it’s important to know what it is, how to avoid it, and how it differs from inheritance tax. Here’s how to tell what an estate requires.

Determine if you Must File Estate Taxes

To tell if an estate requires a tax return, you must know its value. The estate is the value of all of the deceased’s assets. This doesn’t include income the estate earns – that’s income tax and is a separate issue. Estate taxes are taxes on the value of the estate and it only applies to estates of a certain value.

In 2021, estates must pay federal taxes if they are worth over $11.7 million. This is known as the ‘death tax’ and only applies to estates worth over that amount. If you’re a married couple, the limit increases to $23.4 million before it’s taxed.

Fortunately, there are ways around taxation if your estate is worth more than this amount, but it requires working with a professional to ensure you take the appropriate steps.

Completing Form 706

If an estate is worth over $11.7 million, IRS Form 706 must be completed within 9 months of the death. If you need longer, you can request an extension of up to 6 months to complete it. This estate tax form files the necessary taxes on the estate (death taxes).

Note, the current tax reform including the $11.7 million exclusion is only good through 2025. If the Tax Cuts and Jobs Act doesn’t get renewed, the exemption will fall back to its previous level of $5.49 million, which it was in 2017.

How to Determine an Estate’s Value

To determine an estate’s value, you must know the gross value or value before any liabilities for tax purposes. An estate’s gross value is the value of all of its assets at the time of death. The executor can also choose to value the estate six months after the death too if that helps lower your tax liability.

Assets Excluded from an Estate’s Value

In most cases, certain assets are excluded from an estate’s value including:

  • Assets you live to a spouse that’s still alive
  • Assets you leave to charity
  • Some trust assets
  • Gifts you’ve given while you’re alive that are within the gift tax exclusion

Paying State Estate Taxes

Even if an estate is small enough to use the federal exemption, there may be state tax requirements depending on the state you live in and the estate’s value. If your state taxes estates, you must know the exemption limit, and if the estate is worth more than the limit, you must complete Form 706 at the state level.

The state tax exemptions for 2021 are as follows:

  • Connecticut $7.1 million
  • Hawaii $5.49 million
  • Illinois $4 million
  • Maine $5.8 million
  • Maryland $5 million
  • Massachusetts $1 million
  • Minnesota $3 million
  • New York $5.93 million
  • Oregon $1 million
  • Rhode Island $1.5 million
  • Vermont $5 million
  • Washington D.C. $4 million

Who Pays Estate Tax?

If you must file an estate tax return, whether at the federal or state level, the estate is responsible for the taxes. In other words, the executor or beneficiaries aren’t responsible for the tax liability.

The executor, however, is responsible for filing the proper tax returns and paying the taxes due on time (9 months after death). The money comes directly from the estate before the executor can distribute assets to any beneficiaries.

Beneficiaries, in most cases, don’t pay inheritance taxes on the money earned from an inheritance. The IRS doesn’t consider it ‘earned income.’ However, if the inheritance earns an income after the beneficiary takes possession, then the beneficiary will pay taxes on the earnings.

What is Inheritance Tax?

We touched on inheritance tax briefly above, but at the state level, inheritance tax may affect you. Like estate taxes, it depends on where you live. Only a handful of states charge inheritance tax including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Typically, spouse and children do not pay inheritance tax and in some states other blood relatives are exempt, but it varies by location. Some states, though, like Maryland, have both an estate and inheritance tax which means some beneficiaries could get hit twice with state taxes even if the estate is exempt from federal taxes.

Everyone, beneficiaries or executors, though, should watch out for capital gains. That’s what triggers a tax liability – when the estate earns money after the death. It’s best to work with a licensed tax professional to ensure you handle the estate appropriately to avoid excessive tax, while paying what you legally owe.

Do I need to file an estate tax return?

To avoid estate taxes (if your estate exceeds the exemption limit), you can work with a licensed professional to offset the taxation including setting up a trust, giving gifts while you’re alive, or give the money to charity.

If you’re in a state with estate taxes and low exemption limits, you may consider moving if the estate tax will take up too much of your estate and not allow you to leave your loved ones with the legacy you desire.

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Estate CPA

Gilbert, AZ