Attorney, Beaufort, North Carolina, Cecil Harvell
Three Estate Settlement-Related Taxes: A Primer
At Harvell and Collins, P.A., we find that our clients often have questions about tax issues that arise regarding both estate planning and the probate process. The subject of taxes can often be complex and intimidating. Typically, the only experience our clients have with taxation is in filing their own personal income tax returns. Some of our clients may also be familiar with issues related to capital gains taxation on personal investments or to taxes in connection with the operation of a business. However, estate taxation is only triggered upon the death of a loved one. As such, it is natural to have questions about the effect of taxes upon the estate.
While estate taxation may involve issues that are complicated and out of the ordinary for most clients, it is important to understand some of the basics of taxation that occurs within the probate process. The following is a primer on three kinds of taxes that may have an impact on the administration of a decedent’s estate.
- The Estate Tax
Many of our clients are familiar with the concept of the estate tax. However, many do not fully understand how the tax works. Also, some may not know whether the estate tax applies to their estates. The estate tax, sometimes referred to as the ‘inheritance tax,’ or the ‘death tax,’ is a tax imposed upon the transfer of estate assets from a decedent to the beneficiaries or heirs of the estate. As of January 1, 2014 in North Carolina, the “estate tax” actually now consists of only one level of tax imposed at the federal level as the North Carolina General Assembly eliminated the estate tax on the state level. However, the federal estate tax is nevertheless a burdensome one, as it imposes a high rate of taxation upon the value of the probate assets.
The current rate as of January 1, 2014, is Forty Percent (40%) of the net taxable estate. While this may seem high, the rate was actually much higher during much of the twentieth century, hovering in the range Seventy Percent (70%), before being lowered to Fifty-Five Percent (55%) for the majority of the 1980s and 1990s. Still, this recent change reflects an increase from the previous rate of Thirty-Five Percent (35%) which was the lowest rate reached, following steady decreases during the 2000s.
The good news is that these rates apply only to estates whose countable assets exceed $5.34 million, which is an increase over the previous exemption amount. Fortunately for those interested in the administration of an estate, this exemption is currently as high as it has ever been. In 2001, this exemption was set at just $675,000. Even within the past few years it stood at $3.5 million. The way that the exemption works, is that it is applied to reduce the taxable estate by this amount, thus leaving only the remaining value subject to the currently applicable rate of Forty Percent (40%). The bad news is that the IRS uses a broad definition for estate assets. In fact, the gross estate consists of the value of all property (real or personal, tangible or intangible) owned by a decedent or in which the decedent had an interest at the time of death. This can include land, houses, stocks, bonds, bank accounts, insurance, and even certain property that is transferred out of the decedent’s name within three years prior to the date of death.
While it may seem as though clients who do not anticipate a probate estate in excess of this amount have little to worry about, the volatility of the estate tax counsels us against complacency with respect to the current exemption threshold. While the estate exemption has been increased significantly over the past few years, it may just as easily be decreased. Amid continuing discussion regarding the generation of tax revenue, there is a legitimate concern that Congress could return both the estate exemption and the applicable rate to levels closer to what they have historically enjoyed. The recent increase of the estate tax rate in connection with the so-called ‘fiscal-cliff’ issue is an example of this concern being played out in real life.
In short, there is no way to know what future changes may be in store for the federal estate tax. Even clients whose current net worth is significantly lower than the current threshold should participate in sensible estate planning to stay safely within the exemption range. Not only is it impossible to determine one’s net worth at some future date, but it is also difficult to say whether the exemption threshold will return to prior low levels. Through the use of estate planning techniques, such as the strategic employment of trusts, our clients may obtain significant peace of mind with regard to avoiding or minimizing the impact of the estate tax.
- Fiduciary Tax
A fiduciary tax return often arises within the context of the probate process. Basically, the fiduciary tax return is simply an income tax return that applies specifically to a decedent’s estate. The fiduciary, either the administrator or executor of the estate, is required to keep track of all income received by the estate during its pendency. This means from the date it is opened, until the date it is settled and closed. This is an annual tax return. For each year the estate remains open, the fiduciary is required to file a separate tax return.
This tax is only levied against monies received into the estate from which are classified as income. The most common sources of income to the estate are dividends and interest derived from stock, investment accounts, and other bank accounts owned by the decedent. Generally, taxable income does not include cash on hand or other liquid assets which are owned by the decedent at death and later transferred into the estate account. It also does not include cash advances to the estate by the fiduciary or a third party, nor does it include the payment of insurance or annuity proceeds to a named beneficiary. As to the latter scenario, the one exception occurs when the estate itself is the named beneficiary of the insurance policy or annuity. In such case, the transfer may result in taxable income to the estate.
As with estate tax, there exists a threshold below which income chargeable to the estate is exempt from the fiduciary tax. Unlike the estate tax exemption, the fiduciary tax threshold is very modest: only $600 per year. Therefore, a fiduciary is required to file a return if more than $600 of countable income has been received by an estate in a given calendar year. Thus, filing a fiduciary return is often necessary in the settlement of the estate.
Fortunately, the filing a fiduciary tax return need not be costly or burdensome to the client. At Harvell and Collins, P.A., our estate attorneys work closely with local CPAs who are experienced in filing these returns in a timely and accurate manner. The attorneys work closely with the clients to obtain the necessary 1099s and other relevant documents and information, thus facilitating the filing process to make it go as smoothly as possible for the client.
- Capital Gains Tax
Many clients are familiar with the capital gains tax through the filing of their own income tax return. The capital gains tax is imposed upon any profit realized as the result of a bonafide sale of certain assets. Of course, since this is a tax on profit, it only comes into play where the owner of the asset has realized a gain from the sale, meaning that the sale price exceeds the owner’s cost basis in the property. At first blush, such a tax may appear to be of great concern in the settlement of the estate. For instance, the executor or administrator may wish to sell estate assets which have been purchased long ago, during the decedent’s life, and the cost basis of the purchase may be significantly lower than the anticipated sale price.
In fact, the capital gains tax is rarely a concern in the settling of an estate. This is because the decedent’s assets receive a “stepped-up basis” for purposes of determining the capital gains tax. This means that the assets are assigned fair market values as of the decedent’s date of death. Since the cost basis of an asset is never lower than the asset’s value at the date of death, any appreciation of the asset that occurred during the decedent’s lifetime is not taxed as capital gain. This step-up in basis makes a big difference in the subsequent sale of a high-value asset, such as a house.
Of course, it is still possible that the value of an asset may increase between the date of death and the date of sale, either by a beneficiary, or by the administrator or executor. In such a case, this asset appreciation may trigger capital gain taxation. However, when dealing with capital gain taxation within the context of estate settlement, most of the sting is taken out of the tax due to the stepped-up basis rule. Since most estates are settled within a year of the decedent’s passing, little gain, if any, accrues to the estate. Thus, there is little if any tax chargeable to the estate.
Hopefully, this short primer on taxes will put the reader at ease since most estates qualify for exemption from the estate tax, fiduciary taxes are not overly burdensome, and the capital gains tax usually does not apply.