Introduction
Okay, so I was requested to write an article for the TPJ. The request was to the effect that it should be about taxation of decedents' estates, and that it should be informative and interesting. Interesting? Yeah, right. But I decided to give it a try.
The problem is that, while taxes are not inherently interesting, every lawyer and paralegal will probably have to work with the subject at some point in time. It may be a daily function at work in the probate & estate division of a large law firm (or in the boutique estate planning & probate office); it may be only occasionally in a general office practice; or it may be at home or at a party by friends or relatives who feel the right to borrow from your bank of professional knowledge. Unfair as it may be, you are to be expected to be knowledgeable about the less sexy aspects of death. This article is not intended to make you an expert in the field of estate taxation; rather, it will hopefully acquaint you generally with the tax aspects of death, and what you can expect to encounter.
Most people know generally that there is a Federal Estate Tax, and that it primarily takes aim at the wealthy. Of less common knowledge is the existence of Texas' State Inheritance Tax, and of the potential need of a personal representative of the estate (executor or administrator) to file income tax returns for the estate.
In all, there are potentially four (4) different taxes of which you should be aware which are may be imposed upon the estate of a decedents: (i) the Federal Estate Tax; (ii) the Texas Inheritance Tax; (iii) the decedent's Federal Income Tax; and (iv) the estate's Federal Income Tax. (In addition, if the decedent owned property in other states, those states may also impose some form of state taxation.) This article will explain each of these taxes.
The Federal Estate Tax
The Federal Estate Tax (found in the Internal Revenue Code at 26 U.S.C. 2001, et seq.) is, as stated above, primarily aimed at the rich. For people whose estates are less than $600,000, it will not usually be necessary to pay any Federal Estate Tax, or to even file a Federal Estate Tax return. As opposed to the common income tax, which is imposed every year based upon annual income, the Federal Estate Tax is imposed only once, at death, based upon the value of the decedent's estate (i.e., the decedent's net worth).
In general terms, for decedents with net estates in excess of $600,000, the tax rates can range from 37% to 55%. (In 1997, Congress and the President agreed to raise the "$600,000 floor" to $1,000,000; however, this increase is to be phased in over the next 10 years, and most of the increase will not occur until after the year 2000.)
To calculate the Federal Estate Tax, we begin by adding the fair market value of everything that the decedent owned, or in which the decedent had an interest, valued (with certain limited exceptions) immediately prior to the decedent's death. THIS INCLUDES EVERYTHING!: (i) property which the decedent owned outright, (ii) property in which the decedent owned only a joint or partial interest, (iii) life insurance in which the decedent had "incidents of ownership", (iv) the decedent's interests in trusts, (v) other property that the decedent owned, but which does not pass through probate (such as pensions and IRA's), and (vi) even property which may be valueless or nonexistent to the estate immediately after death (such as life estates, annuities, and property held with right of survivorship). Here, two points are mentioning:
First, many people believe that life insurance is not taxable. This is not true. While life insurance proceeds are not generally considered to be "income" to the recipient for Federal Income Tax purposes, those life insurance proceeds are includible in the decedent's estate for Federal Estate Tax purposes if the decedent had "incidents of ownership". This is true whether the proceeds pass to the decedent's estate or to some other person or entity. (Incidents of ownership would include the right to change the beneficiary, to surrender or cancel the policy, to assign the policy, to pledge the policy as collateral for a loan, or to obtain from the insurer a loan against the surrender value of the policy.)
Second, some property which the decedent owned, such as annuities and life estates, may be valueless upon the decedent's death; while other property, such as pensions, IRA's, and property held jointly with right of survivorship, may not even pass to the decedent's estate. Nevertheless, the fair market value of such property, valued as of immediately prior to the decedent's death, is includible in the decedent's estate for Federal Estate Tax purposes.
So, we add the fair market value of everything that the decedent owned, or in which the decedent had an interest, valued as of immediately prior to the decedent's death. This amount is termed the "gross estate". From the gross estate, we are allowed to take deductions for: funeral expenses, administrative expenses (i.e., those expenses incurred by the personal representative in administering the decedent's estate), debts owed by the decedent, mortgages on the property owned by the decedent, bequests to charity, and bequests to the surviving spouse. (It is this last category, deductions for bequests to the surviving spouse, which reduces most estates to $0.00 for federal estate tax purposes.)
Those deductions are subtracted from the gross estate to arrive at the "net taxable estate".
Next, we multiply the net taxable estate by the applicable tax rate (18% to 55% - there's a chart in the instruction booklet) to arrive at the "gross estate tax". From the gross estate tax amount we subtract the "federal unified credit" (currently $192,800) to arrive at the total estate tax.
As an aside, I should take a moment to explain the "federal unified credit". You will recall that I stated above that everything in the net taxable estate in excess of $600,000 will be subject to tax at the rates of 37% to 55%. You will notice, however, that nowhere in our calculation of the estate tax do we subtract-or even mention-this "$600,000 floor". This is because the "$600,000 floor" is actually the same as the $192,800 federal unified credit (that is, the $192,800 federal unified credit actually results in the "$600,000 floor". (So that as the "floor" rises from $600,00 to $1,000,000 over the next 10 years, it is actually the federal unified credit being increased from $192,800 to $345,800.)
For example, if the decedent's net taxable estate is $600,000, then the gross estate tax will be $192,000; and, after subtracting the $192,000 federal unified credit, the net estate tax will be $0.00. Thus, for net estates valued at $600,000 or less, the federal unified credit will eliminate any federal estate tax.
So there we have the federal estate tax. As will be discussed below, this amount may have to be split with the State of Texas.
Texas Inheritance Tax
The Texas Inheritance Tax (found at Tex. Tax Code 211.001, et seq.) is not as commonly known to the public as the Federal Estate Tax; and, in fact, it is not an additional tax at all. It is calculated with reference to the Federal Estate Tax (meaning we don't have to re-calculate the net estate using different amounts and different deductions.)
To calculate the Texas Inheritance Tax, we start with the Net Taxable Estate for Federal Estate Tax purposes (above). From the net taxable estate, we subtract $60,000.00, and then the remainder will be subject to inheritance tax at the rates of 0% to 16.0%.
But instead of paying the Texas Inheritance Tax as additional tax money to the State of Texas, all amounts paid to the State of Texas will reduce as a credit - dollar for dollar - the Federal Estate Tax paid to the Internal Revenue Service. (Therefore, after we calculate the Texas Inheritance Tax, we must go back to the Federal Estate Tax return and subtract the Texas Inheritance Tax amount to determine how much to pay the IRS.)
A minor complication would arise if the decedent owned property out-of-state, in which case the inheritance tax would have to be reduced proportionately. However, this is, in general terms, our Texas Inheritance Tax.
Decedent's Federal Income Tax
It is at this point that I should mention that many decedents do not have the courtesy to die at year end, having just filed their Federal Income Tax returns for the year. In fact, decedents tend to pass away at times throughout the year - and irrespective of whether or not their Federal Income Tax returns have been filed.
While death may relieve the decedents of the burden of paying their federal income taxes (eternal salvation or damnation being their major concern), it does not eliminate those federal income taxes. For these decedents, it becomes the responsibility of the personal representative of the estate to file the decedent's final Federal Income Tax return, and to pay any federal income tax due.
Estate's Federal Income Tax
It is common for a decedent's estate to continue to earn income (interest, royalties, dividends, rent, capital gains, etc.) during the period following the decedent's death, and until the decedent's property is distributed to the decedent's heirs or beneficiaries. Do not think for a moment that the IRS will allow this income to go untaxed.
Just as the decedent earned income prior to death upon which the decedent or the personal representative was required to file federal income tax returns and pay federal income tax, it is the responsibility of the personal representative of the estate to file a "fiduciary federal income tax return" for the estate, and to pay any federal income taxes on the income earned by the estate. (On the other hand, many estates of decedents are settled and distributed soon after death - to the surviving spouse or other beneficiaries or heirs. For those estates, no income will be earned by the estate, so it will not be necessary for the personal representative of the estate to file a fiduciary federal income tax return for the estate.)
Additionally, for decedents' estates which remain open and earning income for more than one year, the personal representatives of those estates will have to file fiduciary federal income tax returns not just once, but annually just as other federal income tax returns are filed.
Conclusion
So there we have an overview of (i) the Federal Estate Tax; and (ii) the Texas Inheritance Tax; each a tax based upon the size and worth of the decedent's estate. We also have been reminded of (iii) the decedent's Federal Income Tax; and (iv) the estate's Federal Income Tax; each a tax based upon income earned by the decedent or the decedent's estate.
Obviously, this has been an overview only; and each of these taxes are subject to numerous exceptions, complications, and other wrinkles. Hopefully, this has provided you a painless introduction to, and with a basic understanding of, the subject.
Michael Z. Stern is a lawyer and CPA practicing in Austin, Texas. He is also a member of the State Bar's Standing Committee on Legal Assistants.