“[I]n this world nothing can be said to be certain, except death and taxes,” as Benjamin Franklin is often quoted. But what comes about when death and taxes intersect? There are four possible taxes associated with death: the deceased’s final income tax return, inheritance tax, fiduciary income tax, and estate tax.
- Deceased’s final income tax return. If the deceased would have been required to file state and federal income tax returns in the year of death, then final income tax returns must still be filed. Remember, the deceased’s personal income tax return will include any business that was operated as a sole proprietorship or “DBA”.
- Inheritance tax. Unlike some other states, New York has no inheritance tax. A beneficiary owes no income tax because of inheritance. If, however, the inherited asset would have been taxable to the deceased, for example because the asset was a tax deferred account like a 401(k) or traditional IRA, then there are similar income tax implications for the person inheriting the asset.
- Fiduciary income tax. An estate is an entity, a “person” in its own right. If the estate has income in excess of $600 in a tax year, then the estate must file annual state and federal “fiduciary” income tax returns similar an individual with taxable income filing income tax returns. Frequently, these returns are necessitated when real property owned by the estate generates rental income or when stock or investments owned by the estate increase in value before being liquidated. Any income generated by the deceased’s sole proprietorship, DBA, or other business reported through the deceased’s personal income tax returns would also become part of the fiduciary tax returns while the business affairs are concluded and wound-up.
- Estate tax. Estate tax can be imposed at both the federal and New York levels, depending on the value of the “taxable estate.” The “taxable estate” is a broad concept, including any assets in which the deceased had an ownership interest, whether the asset passes through the probate estate, i.e., according to the deceased’s Will or the laws of intestacy, through non-probate means such as joint ownership or beneficiary designation, or, beyond the scope of this article, was part of a gift that is pulled back into the taxable estate. An unlimited amount of property may be left to a surviving spouse without incurring any estate tax.
In 2018, each individual is allowed to pass up to $11.18 million free of federal estate tax. This tax benefit is sometimes referred to as the applicable or basic exclusion amount. This amount can be passed through lifetime gifting in excess of the annual exclusion amount (currently $15,000per person per year), through assets that pass at death, or through a combination of the two. Likewise, New York allows each individual to pass an amount free of New York estate tax. For persons dying between 4/1/2017 and 12/31/2018, this amount is $5.25 million. These tax benefits are in addition to unlimited transfers between spouses.
The most important difference between the federal and New York systems is that the federal system provides for “portability”, which allows any of the exclusion amount that was not used at the first spouse’s death to be transferred and remain available for the second spouse. New York does not provide this flexibility. If the first spouse to die leaves all of his or her assets to the surviving spouse, then that first spouse will have lost the benefit of the New York applicable exclusion amount since all the assets will still be included in the second spouse’s taxable estate.
If an individual or a married couple has (combined) assets in excess of $5.25 million that would be included in the taxable estate, estate tax planning is advisable. When considering net worth, remember any business interest owned would be included – fractional interest in a partnership, shares in a closely held corporation, membership interest in an LLC. . . . The business organizational documents and/or buy-sell agreement may provide parameters for valuing such interests. Also included would be the (surrender) value of any life insurance the deceased owned on another person, for example keyperson insurance owned on a business partner. Similarly, an insurance death benefit payable to a spouse should be included when considering net worth.
Estate tax planning might be as simple as reviewing how assets are divided, could involve implementing a plan of lifetime gifting, or incorporating flexible provisions such as credit shelter trusts or disclaimer charitable gifting into the couple’s estate planning. It goes hand in hand with business succession planning. The New York estate tax is particularly dangerous because the tax imposed on estates in excess of $5.25 million can be more than the amount by which the threshold was exceeded. For example, exceeding the exclusion by $62,500 could result in a tax due of $107,025 in that case, it is literally better to give assets away to a charity than to pay the estate tax!
Watch for Part Two of this article for an in-depth look at some of the strategies to minimize or avoid New York estate tax. Many Wills drafted before 2006 contain outdated or rigid provisions for trust funding and tax planning, and more recent Wills may not include the flexibility advisable today. Remember, you should periodically review all your estate planning documents with your attorney and/or tax accountant, particularly after major life events, family changes, or tax law changes.