All About Taxes with an Estate Planning Flair: Part I

In a famous quote by Benjamin Franklin, “nothing can be said to be certain, except death and taxes.” Now taxes are not fun; however, they are certain, and there are many different kinds of taxes. In estate planning, we deal with several different types of taxes, and people often mix them up. Here we will lay out the different types of taxes and how they pertain to your estate plan.

There are several levels of taxes: beginning with federal taxes, or those imposed by the Internal Revenue Service (IRS); followed by state taxes, in California, they are imposed by the Franchise Tax Board; and lastly, local taxes which are typically imposed by the city or county in which you live.

The first part of this three-part series will address Federal taxes and the five types of federal taxes that impact estate planning.

Federal Taxes: Income Taxes
The first type of federal tax that affects estate planning is individual income tax. Income tax can apply to individuals, married couples, and entities, including trusts. Income tax is a tax on direct income such as earned income (wages and tips) and unearned income (social security, pensions, annuities, distributions of income from a trust, interest, and dividends). As individuals, we file a 1040 Income Tax Return, and estates and irrevocable trusts file a 1041 Income Tax Return.

Federal Taxes: Capital Gains
The second type of federal tax that commonly affects estate planning is capital gains. Capital gains are most prevalent when it comes to selling a property or selling securities. A simple explanation would be that you are taxed on the profit, and your profit is the amount you sell an asset for minus the amount you purchased it for (typically called your tax basis). A tax preparer or accountant will tell you it’s more complicated than that, because it is. For real estate, there are capital improvements and depreciation to take into account.

With real estate that is your residence, you are allowed an exemption on your capital gains. If a single person sells their residence, they are allowed up to $250,000 of tax-free gain; if a married couple sells, they are allowed up to $500,000 of tax-free gain. However, the seller must meet an ownership test and a use test, meaning that you must have had to own the home and used it as your primary residence for at least two out of the five years prior to the date of sale.

Federal Taxes: Estate Taxes
Also known as the death tax, estate tax is a tax paid if an individual is worth more than a certain amount upon death. Historically this has been a significant factor in setting up trusts for estate planning. Currently, the estate tax exemption is $12.06 million per person, meaning that your estate will be taxed on all dollars after the first twelve million sixty thousand dollars ($24.12 million for a married couple). Current legislation holds that this number will go down in 2026 to $6.03 million dollars per person. This number could also change with any act of Congress.

What all of this means is that if your estate is worth more than the exemption amount, the trustee of your trust or executor of your estate will have an estate tax return prepared by a tax professional (Form 706) and pay these taxes as a part of the administration of your trust or estate, if applicable, and then carry out your wishes regarding your beneficiaries.

Federal Taxes: Gift Taxes
A gift tax is a federal tax paid by a person who makes a gift of something of value to another person. As of 2022, you can give $16,000 to as many individuals as you want without anyone having to report the gift to the IRS. However, if you give more than that to any individual, you must report that gift to the IRS on a gift tax return (Form 709). The IRS keeps track of your lifetime gifts. The gifts count toward a lifetime gift tax exemption amount. The lifetime gift tax exemption amount is tied to the federal estate tax. That means that if you pass away before 2026, your $12.06 million dollar estate tax exemption will be reduced dollar for dollar for the amount of reportable gifts you have made during your life. What if you gifted $11 million during your life and died in 2026 when the estate tax is $6 million? The IRS has ruled that beginning in 2026, your estate tax exemption will be the estate tax exemption, then in place the year you die or the total taxable gifts you have made during your life, whichever is greater.

Federal Taxes: Generation-Skipping Transfer Taxes
The generation-skipping transfer tax (GSTT) is an extra tax on a transfer of property that skips a generation, known as a generation-skipping transfer (GST) for short. This tax was implemented to prevent families from avoiding the estate tax for one or more generations by making gifts or leaving money directly to grandchildren or great-grandchildren – the parent’s generation being skipped in order to avoid an inheritance being subject to estate taxes twice, first on the grandparents’ death, then the parent’s death. The GST ensures that grandchildren end up with the same value of assets they would have had if the inheritance was transferred to them directly from their parents rather than their grandparents. Essentially, the IRS gets their estate tax regardless of the generation receiving the inheritance. The GST closed a loophole that the very wealthy had been exploiting. Like the estate tax, there is an exemption amount currently tied to the estate tax, $12.06 million for 2022, and the GST tax is not imposed unless there was a transfer to a skip-person (typically grandchildren or great-grandchildren) that exceeded the lifetime exemption amount of the transferor.

You may have noticed that inheritance taxes were not mentioned. That is because no federal inheritance tax is imposed on people who inherit money from their families. The federal estate tax is imposed on the estate and not on the recipient of the money. Therefore, there is no additional federal tax imposed just because you inherited assets. However, there may be an inheritance tax imposed by your state.

Look for Part II next month, where we discuss taxes imposed at the state level. In addition, please reach out to your estate planning attorney or certified public accountant if you need to know how these federal taxes affect your specific situation.

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