There are several types of tax that may apply when a person dies. Failure to plan for these may result in higher taxes, imposition of penalties or interest, and lost opportunities. Some of these taxes are:
Federal & State Income Taxes. Death does not absolve the obligation to pay income taxes. The decedent’s final federal income tax return (and state, if applicable) must be completed and any taxed owing must be paid. (Of course, it’s also possible that a refund will be due!) The person responsible for filing this return is the executor named in the Will, but if there was no probate proceeding then the person named in the Will, the trustee, or someone inheriting property from the decedent can file the return. If the final tax return is not filed, or if taxes are due, the person responsible for filing may be personally liable and the heirs will have to pay the taxes from the inheritance they received.
Federal Estate Tax. The estate tax is essentially a tax on the privilege of giving your property away at your death. As of January 2013, the amount exempt from tax is $5 million, with an annual inflation adjustment. If the value of your “taxable estate” is less than the exemption amount, no tax is owed. If it’s higher, the maximum tax rate is 40%. (This is all good news! The exemption amount used to be as low as $675,000 and the maximum rate was once 55%!) These amounts are subject to the whims of Congress — changes in the estate law laws are revisited with every administration.
The “taxable estate” means any property owned at the time of death, any life insurance owned by the decedent, certain property over which the decedent had too much control (such as the ability to assign an estate to his estate) and any gifts given within three years of death. The exemption amount may be reduced by the making of lifetime gifts in excess of the annual gift exclusion (currently about $14,000 per person per year).
If you think you will have a taxable estate, there are planning methods available to help reduce those taxes. These include leaving assets to a spouse (which are deductible), charitable giving, gifting of appreciating assets during life, purchasing life insurance to cover the estate tax, and other options. If the proper steps are taken, it may also be possible for the surviving spouse to carry any unused portion of the deceased spouse’s exemption over to the surviving spouse’s estate when the second spouse dies. This could result in a higher total exemption on the death of the second spouse.
Inheritance Tax and State Death Taxes. California does not currently (January 2013) impose an inheritance tax or a state death tax. But some states do impose one or both taxes. If the heir lives in such a state, or if the decedent owned real property in such a state, then these additional taxes may be due.
Other Taxes. Generation Skipping Transfer (“GST”) tax, real estate taxes, and gift taxes may all be triggered as well. The GST is a federal tax similar to the estate tax, but applies when a person is giving assets to someone more than one generation younger. At present, GST has an exemption amount equal to the estate tax exemption. If gifts in excess of the annual gift exclusion were given during the decedent’s lifetime, and a federal gift tax return was not filed, it must be completed now and the gift taxes paid, together with possible penalties and interest. In California, transfer of real property — even by inheritance — can result in higher property taxes, unless an exemption applies and is timely claimed. This may be true in other states as well.