Income taxes, federal and state, are a pain everyone feels. We shelter and plan to reduce, as much as we can, how much we owe each year in income taxes.
When planning your estate, however, there are additional things to consider.
- Gifts that aren’t compensation generally leave the recipient owing no income tax on that value because the giver can be charged a “transfer tax.”
- Gifts that pass to a person because of someone’s death, i.e., through instruction in a Will or Trust, get a “step up in basis.” This is an accounting term-of-art that basically means that the IRS pretends that no income tax — capital gains or ordinary income — will be owed on a property’s value growth as of the date of the death of the giver. Any market growth in the asset after that date will still be income taxable.
- The deceased person’s estate or trust will still owe “IRD,” or Income in Respect of a Decedent, for income that come into the estate of that person after their passing but before the asset was officially transferred to the specified recipient. The person administering the estate or trust will then file a tax return for the decedent in April of the year after the year they passed away.
- Income tax can also be charged against a trust after the passing of the last person who established and funded that trust. The problem here is that trusts are income taxed at highly compressed rates, meaning that the top marginal tax rate is charged against far smaller assets values, so income taxes balloon to be much higher against a trust than against an individual. This is why irrevocable trusts are written so that they must send all their income from investments out to the beneficiaries of the trust at least every year. That leaves the income to be taxed to a natural person at their normal rate and bracket structure.
This is one of many reasons why people need to consult with competent professionals so they don’t end up paying more in income or transfer taxes than they had to.
Proper planning and structuring can save the day.