Will My Heirs have to Pay Taxes upon my Death? An Introduction to Estate Tax Law

New Hampshire
New Hampshire currently has no gift or estate tax. It has had an estate tax in the past and the Legislature has considered reinstating some form of estate tax from time to time. Every other New England State imposes an estate tax, and Connecticut also imposes a tax on lifetime gifts. Many New Hampshire residents own property in one of these States, or in other States that impose an estate tax. If you own property in another State, it is important to seek advice about how to reduce or avoid any such taxes that might apply.

United States
The federal government imposes a tax on certain gifts made during lifetime and on bequests made at death. The U.S. has what is referred to as a “unified gift and estate tax” on the transfer of assets during life and at death, which applies only after an individual has used up their entire lifetime gift and estate tax credit. If the tax applies, the rate is 40%.

For the year 2014, the federal gift and estate tax credit is $5.34 million (under current law, this figure will be adjusted annually for inflation). The existence of this credit means that each of us may give up to $5.34 million (during life and/ or at death) without incurring any estate or gift tax. In addition to the $5.34 million credit, there is an unlimited “Marital Deduction,” so that most property left to a US citizen spouse is entirely exempt from the federal estate tax. Any property left to a qualified tax-exempt charity is also free of federal estate tax.

In 2010, a new feature was added to the federal estate tax law which benefits married couples. This feature is known as “portability,” and it provides that any unused estate tax credit of a decedent may be effectively transferred to the surviving spouse. For example, if the first spouse to die uses only $1 million of his total $5.34 million credit, then the surviving spouse will receive the remaining $4.34 million of unused credit. The surviving spouse can then apply the additional credit to her own lifetime gifts or bequests at death. In order to take advantage of this portability feature, the executor of the estate for the first spouse to die will need to file an informational federal estate tax return (Form 706) with the IRS.

To calculate the value of an estate, the law requires a determination of the “fair market value” of the decedent’s “taxable estate,” which includes all assets such as real estate, bank accounts, tangible personal property, stocks, bonds, business interests, annuities, retirement accounts (such as IRAs and 401Ks), and life insurance. In some cases, it is necessary to hire an appraiser in order to obtain a formal valuation of the assets as of the date of death.

Much of estate tax planning focuses on removing an individual’s assets from their “taxable estate.” This can be done with outright gifts, or with certain gifts or bequests in Trust. There are also a number of sophisticated tools that may reduce the value of one’s property for tax purposes or that create non-taxable “wealth replacement,” for example. If your estate might be subject to the federal estate tax, you should seek advice about how to reduce your taxable estate in order to potentially eliminate the federal estate tax for your heirs.

Income Taxes
The federal estate tax is not to be confused with the federal income tax. These are entirely separate taxes, and in some cases, both will apply. In situations where no estate tax is imposed because the decedent’s estate is less than the credit amount (currently $5.34 million), the heirs may still have income taxes to pay. Although under federal and New Hampshire law, the receipt of an inheritance is not taxable, there may be income earned during the administration of an estate or trust which is taxable. Estates and trusts must file their own federal income tax returns, and the income earned is often “carried out” to the beneficiaries of that estate or trust, to be reported on the beneficiaries’ own personal income tax returns. Beneficiaries who withdraw money from tax deferred assets (such as IRAs and 401Ks), will also need to pay income tax on those withdrawals. At the same time, holding highly appreciated assets until you die may result in a “step-up” in tax basis that could significantly reduce income taxes (in the form of reduced capital gains tax) for your heirs.

Changes in the Law
Over the last several decades, the federal estate tax law has seen many changes. The estate tax credit has been as low as $675,000 in the year 2000 (so that many more estates were concerned about the tax at that time) to as high as the $5.34 million credit we have today. At times, the US gift tax credit has been lower than the estate tax credit, and in one year (2010) there was no federal estate tax at all! Suffice it to say that this is an area of tax law that Congress has frequently amended, so clients are advised to keep track of any such changes, and to seek advice about how new laws might impact their individual estate plan.