Inheritance and estate taxes can also impact ordinary taxpayers
The news that King Charles III will not have to pay tax on the assets he inherits is making headlines this week. Some chatter suggests that a full tax exemption is a perk of being royal, while others have claimed that no exemption applies to more ordinary taxpayers. Both premises are false.
It is true that King Charles will not have to pay inheritance tax on certain assets he inherited from his mother following an agreement reached between the royal family and the tax authorities in 1993. A protocol of 2013 agreement further clarified and expanded the agreement, clarifying two things:
- Property held by the monarchy is not subject to inheritance tax; and
- Certain properties considered private but also for official use – such as Balmoral, a Scottish residence belonging to the royal family – and which will pass from one sovereign to another, will not be subject to inheritance tax. (If these assets were transferred to someone else, the exemption would not apply.)
Inheritance tax in the UK
Apart from the Royal Family, UK residents and taxpayers who own UK taxable property would normally pay 40% tax on assets over the £325,000 exemption amount – a reduced rate applies if you leave certain assets to charity. Certain special rules and exemptions may also apply – it is tax law, after all.
Federal estate tax
While we don’t have a royalty exception in the United States, we do have a large exclusion available: the federal estate tax exemption in 2022 is $12,060,000 per person or $24,120,000 per married couple.
Here’s how it works.
US taxpayers are generally subject to tax on assets in their own name or on assets they control, including property located outside the country. Your assets may include financial interests such as cash, bonds and stocks, as well as real estate, business interests, insurance products, works of art and collections. Deductions, including your debts and expenses related to the administration of your estate, are deducted from your assets on Form 706, and the result is what is called your taxable estate.
This is where things get complicated. When you calculate the value of your estate, you add back the value of taxable gifts for life, starting with gifts made in 1977.
Taxable donations are donations that exceed the annual exclusion amount. For 2022, this amount is $16,000. This means you can donate up to $16,000 per person in 2022 without being subject to gift tax. It should be noted that you can make unlimited gifts to US citizen spouses. But what if you donate $100,000 to someone other than your spouse? This excess of $84,000 is a taxable gift, usually reportable on Form 709.
But even if you’re making a taxable donation, you don’t have to pull out your checkbook. Realistically, most taxpayers do not pay gift tax. Any lifetime taxable gifts just eat into that federal estate tax exemption amount. To understand how this affects your estate, you will actually add these taxable gifts to your estate.
This is the part that gives adjustments to taxpayers and professionals. When you calculate tax, you technically calculate the interim tax due and then reverse the applicable credit amount. This credit is equal to the tax on the applicable exclusion amount.
That’s a lot of math. Therefore, generally, you can simply use the federal estate tax exemption amount each year to determine whether you would be subject to tax. Spoiler alert: most taxpayers aren’t, and most estates aren’t even required to file a tax return.
Federal Estate Tax Return Data
In 2020, the last tax year for which complete data is available, only 3,441 federal tax returns were filed. More than half were non-taxable returns. This would include returns where assets passed to a charity or spouses, resulting in no tax, and where returns were required to be filed, but no tax was due.
Also, some returns are filed as an election and not for tax payment purposes. Indeed, as of 2011, the IRS announced married deceased persons could pass on the unused portion of their disqualification amount – rather than wasting it – to the surviving spouse by timely filing a Form 706.
Because federal estate tax returns are due nine months after the date of death, most returns filed in 2020 were for people who died the previous year. In 2019, 2,854,838 deaths were reported in the United States. The difference between these numbers – statements filed versus deaths – is significant.
The number of federal estate tax returns that would need to be filed will likely continue to decline as exemptions continue to increase. Experts are waiting for the amount of the exemption increase to around $13.1 million by 2025 (assuming 3% inflation in each of the next three years, which seems like a bold assumption) and then drop to around $6.8 million in 2026. The drop is because Congress only temporarily increased the exemption amount in 2018. It will return to the 2017 level of $5 million, adjusted for inflation.
And if your mind goes back to the previous description of estate tax calculation, you may be wondering how estate tax will apply to gifts that were made before the fall. The IRS has clarified that taxpayers who take advantage of the exclusion amounts from 2018 to 2025 can do so without fear of losing the benefit of the tax-free transfer. According to the Final Settlement, the estate may calculate the credit using the higher of the basic exclusion amount applicable to gifts made during his lifetime or the basic exclusion amount applicable at the date of death.
Inheritance and Inheritance Taxes
Taxpayers who escape federal estate tax on death—remember, that’s most of us—may still have a hurdle to clear: estate and estate tax at the estate level. state or district.
What is the difference? Generally, an inheritance tax is a tax on the right to transfer property on death. An inheritance tax is a tax on the right to receive property in the event of death. Some states, like New Jersey, had both. Currently, only Maryland charges an inheritance and estate tax.
In addition to Maryland, five states have estate taxes: Iowa, Kentucky, Nebraska, New Jersey, and my own state of Pennsylvania. In most cases, property transferred to the spouse is exempt from inheritance tax. Some states also exempt inheritances to children or tax them at a lower rate.
Eleven states – Connecticut, Hawaii, Illinois, Maine, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont and Washington – plus the District of Columbia impose an estate tax.
So how do you pay these taxes? Unless there are arrangements to exempt you from tax – not all of us will get the royal treatment – you can take action to reduce or eliminate the amounts due. But keep a few things in mind:
- Pay attention to the source. Just because something is widely shared on social media doesn’t mean it’s true. For example, transferring personal assets to a business or revocable trust generally does not exempt them from tax.
- Know the differences between federal and state rules. For example, life insurance is generally taxable for federal purposes, but may be exempt for state purposes.
- Understand the terminology. Probate assets are those that pass through your will. Making your assets non-probate will not necessarily make them non-taxable.
- Do the math. Tax planning is smart, but don’t be so blinded by the idea of saving tax that you lose money in the process. Paying to set up an entity to protect assets from tax may make sense for some taxpayers, but for others it could be more expensive to set up than paying the potential tax.
- Think about your lifestyle. Changing title to assets or relinquishing control of assets simply to avoid tax can create problems in your lifetime. Make sure the reward is worth all the risk.
- To ask questions. If big chunks of this article give you a headache, don’t go to Google. Ask a professional for help. A reputable professional will review your assets and personal circumstances, then develop a plan that works best for you.
This is a regular column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest tax news, tax law and tax policy. Look for Erb’s column each week in Bloomberg Tax and follow her on Twitter at @taxgirl.