The following is a general discussion about the current law of estate taxes. It is meant to supplement a conversation with an attorney and should not be used for specific estate planning without consulting an estate and/or tax planner.
Your “Estate” Defined:
The size of your estate. An estate consists of all assets you own when you die – whether the asset passes under your Will or passes directly to a surviving named beneficiary or passes to a surviving joint owner. Your estate includes, in some cases, assets which you gave away during your lifetime if you retain some sort of enjoyment and/or ownership interests. And your estate might also include prior taxable gifts.
The Federal Estate Tax Exclusion.1
The good news is that estate tax is not computed on the entire value of a person’s estate. When computing the estate tax, every taxpayer’s estate is entitled to exclude a certain amount – called a federal exclusion – which reduces the size of decedent’s taxable estate. Assuming that a person has not made any taxable gifts during his or her lifetime which would reduce the exclusion amount, then a decedent’s estate would be eligible for the entire federal exclusion amount.
The exclusion amount is $12,060,000 for decedents who die in 2022. Note however, that for decedents dying on or after January 1, 2026, the exclusion reverts to $5,000,000 (indexed for inflation) unless Congress acts to extend the exclusion amount or reduce the exclusion amount. Taxable estates that exceed the exclusion amount will have the excess taxed at a flat 40% rate.
If a married couple is planning, the survivor of the married couple may be able to use his/her own exclusion amount plus any unused portion of the first-dier’s exclusion amount. This mechanism to carry over the first-dier’s unused exclusion amount is called “portability”. If both spouses die between 2022 and 2025, they could have a combined exclusion amount of $24,120,000. To elect portability, it is necessary to file an estate tax return in the first-dier’s estate. Again, even if no tax is due, the return must be filed.
The New York State Estate Tax Exclusion.2
The exclusion amount is $6,020,000 for decedents who die in 2022. If the decedent’s taxable estate is below the exclusion amount, then there is no NYS estate tax. NYS does not recognize portability to recapture the unused exclusion amount of the first spouse to die. When computing a decedent’s taxable estate, NYS does include some prior taxable gifts, but NYS does not include real or tangible property located outside of NYS. If the taxable estate is below the exclusion amount, then there is no NYS estate tax. NYS has added a “phase out” amount of 105%. If the taxable estate is between the exclusion amount and the phase out amount (referred to by some as a “black hole”), then the estate tax could be higher than the amount by which the estate is larger than the exclusion amount. I realize this makes no sense, but it is the law. There are however some ways to reduce the tax impact if a taxable estate falls within the black hole, and we can discuss them if appropriate for you.
If the taxable estate is equal to or exceeds the 105% of the exclusion amount, then the entire taxable estate is taxed (starting at dollar one). The maximum rate is 16%.
A gift is a transfer during lifetime for no consideration. The giver of a gift is called a donor. The recipient of a gift is called a donee. The annual gift tax exclusion amount increased to $16,000 starting in 2022 up from $15,000 per donor per donee per year. A person can make an unlimited number of gifts per year to anyone (friends, relatives, strangers). A person can make larger gifts too, but gifts in excess of the federal exclusion amount require the filing of IRS form 709 and will reduce the lifetime federal exclusion amount by the excess.
Some gifts do not have a maximum: gifts for tuition and gifts for certain medical and medical-related expenses. Gifts for tuition must be made directly to the educational institution. Gifts for medical expenses must be made directly to the medical provider. Medical related gifts include paying for someone else’s health insurance premiums and long-term care insurance premiums and these gifts must be made directly to the insurance providers. To compute the federal estate tax, the IRS adds back in all prior taxable gifts3 made in or after 1976.
NYS does not have a separate gift tax, but NYS adds back in some prior taxable gifts for purposes of computing the NYS estate tax. NYS adds back in prior taxable gifts made within 3 years of decedent’s date of death, but will not add back gifts made prior to April 1, 2019, or gifts made on or after January 1, 2026 (unless the law changes again).
Even if the prior taxable gift is added back in to compute estate tax, gifting might still have beneficial income and estate tax effects.
The Marital Deduction.
In addition to the exclusion amounts, neither the IRS nor NYS impose any gift or estate tax consequence when married couples pass property between them during their lifetimes and at the death of the first spouse provided the assets pass to the surviving spouse (called the unlimited marital deduction).
The Charitable Deduction.
In addition to the exclusion amount and the marital deduction, both the IRS and NYS permit each decedent’s estate to take an estate tax charitable deduction which reduces an estate dollar-for-dollar to the extent of the decedent’s bequests to IRC-approved charities.
Step-Up in Basis Rules.
Unrelated to the exclusions and deductions, but also important for estate and income tax planning, is an asset’s original value – basically, its cost basis.
The value of decedent’s property is stepped-up to its value on the date of decedent’s death. This is called a step-up in basis. The date-of-death value becomes the new cost basis for the person inheriting the property. Basis will have an impact on the amount of gains tax (income tax) due when the property is sold.
The donee of the gift treats the gifted property at its cost basis when determining the amount of gain or loss if the donee sells the gifted property.
The inheritor of property treats the inherited property at its stepped-up basis when determining the amount of gain or loss if the inheritor sells the inherited property.
Note that property which is gifted away by decedent during his or her lifetime does not get a step up to the date-of-gift value. It is possible though for decedent to make a gift during his lifetime and retain some sort of interest for his or her lifetime (as defined by law) such as a life estate. If the donor retained (the correct) interest, then the value of the property is included in decedent’s estate. Yes, this increases the value of decedent’s estate, and an estate tax might be owing, but it is possible that no estate tax will be owing or that the estate tax might be lower than the income tax which would be imposed. It is always necessary to weigh the impact of estate tax vs income tax when contemplating gifting.