How I Got Here

After spending several years in the restaurant industry in my native San Francisco, I decided to go to Law School in the Midwest. Graduating in 2004, I moved back home to practice Real Estate Law. After ten years working largely in Land Use, I obtained an LL.M. in Taxation from the University of San Francisco in 2015. I have worked in the public accounting space for the last five years, focusing on high net-worth individual and partnership compliance.

This blog is a collection of things I’ve learned over the years and designed to be a basic resource for those interested in real estate, taxation, and wealth management. My great hope is that you find the content useful. Any feedback is greatly appreciated and will be thoughtfully reviewed. I strive to “get it right,” and to be quick to correct if I do not. Thanks for reading!

ESTATE TAX BASICS

Overview

Although the federal Estate Tax regime only applies to a small percentage of potential filers, those to whom it does apply need to be mindful of a number of nuances of Estate Tax when filing a return. This article may be used as a primer to assist clients with Estate Tax compliance.

Estate tax is a tax on the transfer of property after death. The tax applies to the amount of assets that exceed the decedent’s remaining Unified Credit (see below) The good news is that the Estate Tax only applies to about 0.2% of US taxpayers. However, the tax rate for those estates to which the Tax does apply is generally 40% of any overage. Some states also assess an estate tax, but property left to a surviving spouse is generally exempt. 

Form 706

IRS Form 706 –United States Estate (and Generation-Skipping Transfer) Tax Return — is the form used by estate executors to determine asset values and report estate taxes according to Chapter 11 of the Internal Revenue Code. The deadline to file Form 706 is nine months after the death of a decedent. It is filed for the calendar year in which a US resident or citizen dies.

Who Must File

The Form must be filed by the estate executor if the value of the decedent estate exceeds the decedent’s remaining Unified Credit (see below). It may also be filed by the executor in order to port any remaining decedent credit to the surviving spouse. 

What Is Taxed

Generally, all estate assets fall under the Estate Tax regime. Form 706 assists executors to determine the value of an estate prior to distribution of assets from it to beneficiaries as outlined in the decedent’s will. The amount of the estate exceeding the decedent’s remaining Unified Credit is generally taxed at a federal rate of 40%. Inherited assets are treated on a stepped-up basis (cost basis is adjusted to fair market value at date of death). This means that unrealized capital gains on estate assets held at death are not subject to income tax, nor are inheritances taxable income to beneficiaries.  

Unified Credit

The Unified Credit is a total lifetime credit given to every taxpayer. For the 2020 tax year, the Unified Credit is $11.54 Million. This credit exempts assets held at death from Estate Tax, and gifts made while alive from Gift Tax. The credit is “unified” as the two tax schemes are integrated. That is, gifts made during one’s lifetime reduce the credit by the gift amount. There is an annual Gift Tax exclusion of $15,000 per recipient. Thus, a married couple with two children could gift them a total of $60,000 each year ($15,000 from each parent to each child) without any Gift Tax or Unified Credit consequence. The annual Gift Tax exclusion is not limited to family members; an individual may gift as many people as desired up to $15,000 a year without paying any Gift Tax.

For example, if a decedent made two gifts while alive of $1,000,000 each and then died in 2020, his remaining Unified Credit would be $9.54 Million. If the decedent has a surviving spouse, the remaining credit would be transferred (or “ported”) to this spouse, who would add that amount to his or her own Unified Credit.

Filing Deadlines

Form 706 must be filed and all taxes that are due paid in full within 9 months after the death of the decedent. An automatic extension of 6 months is available for all estates by filing IRS Form 4768. Note that the filing of Form 4768 does not extend the amount of time for payment of any taxes due; these must be paid within nine months of death, lest penalties and interest accrue.  There is the possibility of an additional extension in special circumstances. 

State Taxes

California, like most states, does not levy an estate tax on any estates, regardless of size. However, there are currently fifteen states and the District of Columbia that have an estate tax. Generally, a deduction is allowed for state estate tax on the federal return. Additionally, six states have inheritance tax, which is paid by the heirs upon distribution of the estate. Tax rates are often determined by the heir’s relationship to the deceased, with more distant relatives paying the highest tax. One state (Maryland) has both an estate tax and an inheritance tax. 

When Should a Non-Taxable Estate file Form 706?

Certain estates that do not have to file an Estate Tax return (i.e, those that are valued at less than the decedent’s Unified Credit) should still consider filing Form 706 . Doing so locks in the market values of estate assets to the date of the decedent’s death, providing optimal tax treatment for heirs should they later decide to sell the assets. It is also useful for estates which create lifetime trusts providing benefits to non-spouse beneficiaries. Filing an Estate Tax return will make it a lot easier when settling the estates of a non-spouse beneficiary or a surviving spouse when they die, as these assets have already been valued. The fair market values and stepped up basis of all the estate’s assets are clearly given on Form 706.

Conclusion

Estate tax applies to relatively few estates. The necessity of filing an Estate Tax return is determined by the total value of the decedent’s estate and the Unified Credit. For some estates that are not required to file Form 706, it may make sense to do so anyway to lock in asset values at death and make subsequent sales and distribution of assets as straightforward and tax favorable as possible. A skilled practitioner will carefully consider these points when advising clients who file Estate Tax returns.