How Probate Affects Taxes

When you pass away, your estate will be administered and distributed according to your will, under your state’s probate law. This does not take care of taxes automatically. The appointed administrator of your estate will be responsible for federal and state taxes among other obligations of your estate.

Federal and state tax laws provide for generous exemptions. Therefore, few estates will owe taxes or even file a return.

Who Handles Estate or Inheritance Taxes?

If your estate owes estate tax, your executor will file federal and state estate tax returns.

One of the core provisions of a will designates a person to act as executor for the deceased’s estate (if you do not have a will, the probate court will appoint an administrator). The executor’s first act will be to file the will with the state’s probate court. In most cases, the probate court will supervise every aspect of the executor’s management of your estate until probate is closed.

Your probate and tax considerations will depend on your state of residence and the location of your assets. You need the advice and counsel of a licensed trust and estate lawyer where you live.

Beginning Estate Taxation Through an Inventory

A primary duty of your estate executor or administrator is to give the probate court an inventory of the estate’s assets. The inventory must include a valuation. The valuation is necessary to allocate assets for distribution to your heirs according to your will or in compliance with intestacy laws.

Your will might provide that your estate is to be divided equally among your heirs. If all of your estate assets could be distributed without being modified, the task would be easy. In practice, this is usually not the case. For example, a principal residence can’t be divided. A valuation establishes what beneficiaries should receive once assets are sold.

Federal and state estate taxes, and state inheritance taxes, are based on the gross value of your assets transferred. Your estate may be subject to federal or state estate tax. The inventory of your assets filed with the probate court will establish their taxable value.  This is the principal effect that probate has on taxation.

Tax Considerations and the Unified Lifetime Exemption

If, during your lifetime, you transfer assets by sale, they would be subject to capital gains tax on the difference between your proceeds from the sale and your basis. Your basis is usually what you paid for them or your cost of producing them. The buyer would take the assets with a stepped-up basis equal to what they paid for them (that is, their new value at the time of transfer).

Federal gift and estate taxes are taxes imposed on the transfer of assets. The assets typically have built-in unrealized gains in value at the time of transfer. 

When you transfer assets by gift or testamentary bequest, the transferee will take them with a stepped-up basis equal to their fair market value. Since the transfer is not a sale or exchange, there is no capital gains tax. Instead, the gift and estate taxes are the government’s way to get their pound of flesh on the built-in gain.

Taxation of gifts and testamentary transfers is based on the value of the transferred assets.  However, both taxes allow an exemption of a certain amount of value. Gift and estate taxes share one Unified Lifetime Exemption.

Over the years, legislation has gradually reduced the number of returns required. In 2001, estates were subject to federal estate tax to the extent they exceeded the Unified Lifetime Exemption of $675,000. The top tax rate was 55 percent.

Lifetime Exemption Levels Before Taxation

The estate and gift taxes share a Unified Lifetime Exemption. You can make cumulative lifetime gifts and testamentary transfers for up to the Unified Lifetime Exemption without taxation. 

The Unified Lifetime Exemption is currently $12,920,000 for an individual, or $25,840,000 for a married couple. In 2026, the Unified Lifetime Exemption will return to its previous level of about $7 million per individual or $14 million per couple (the exact amount will depend on inflation). An estate will be subject to tax only to the extent that it exceeds the exemption amount. However, the exemption has been adjusted multiple times in the past few decades and may change again.

The tax rate on the taxable amount is graduated starting at 18 percent and reaching 40 percent on taxable amounts over $1 million.

You can’t control when you die. However, you and your tax advisor should explore before 2026 whatever tax-saving measures might be available.

Federal Estate Tax

The federal estate tax (sometimes called the “death tax”) is levied on the value of a deceased’s estate. The estate’s executor or representative is required to file an estate tax return. In 2020, out of 3,378,414 deaths that occurred in the U.S., only 4,100 estate tax returns were required; and only 1,900 of those returns filed owed estate tax.    

The federal estate tax is a tax on the transfer of a deceased’s estate to their heirs. It applies to  citizens and residents of the United States. Taxable transfers include those made by will or under state laws of intestacy.

Government revenues from gift and estate taxes are small compared to revenues from income tax. For that reason, the U.S. Treasury has long held that gift and estate taxes are not worth the administrative cost. It costs almost as much to administer the tax as the revenues derived. Accordingly, the Treasury Department has supported legislation that effectively diminishes the number of estate tax returns that need to be filed.

Payment of the estate tax is the responsibility of the executor or other representative. The estate tax return must be filed on Form 706 within 9 months from the date of the decedent’s death. The payment of the tax may be extended not more than 12 months. 

Federal Gift Tax

The federal gift tax is imposed on transfers by lifetime gift. The policy is the same as for the estate tax. It is intended to prevent avoidance of tax as a result of a stepped-up basis for appreciated assets.

Generally, a donor will pay the tax on their gift. However, individuals receiving a gift can arrange for the option to pay it instead. Gifts must be reported on IRS Form 709.

Donors can give $17,000 each year to an unlimited number of separate individuals without incurring a gift tax. These annual exclusions are separate from the unified lifetime exemption.

State Taxation of Asset Transfers

In addition to the federal government, 17 states tax testamentary transfers. 

Taxing the Deceased’s Estate: Eleven states and the District of Columbia impose an estate tax on the deceased’s assets. 

Taxing Heirs: Six states levy “inheritance taxes” on a person who receives money or property from a deceased’s estate. 

Double-Taxing Estates and Heirs: Maryland imposes both an estate tax and an inheritance tax.

Generation-Skipping Transfer Tax

Before the enactment of the Generation-Skipping Transfer Tax (GSTT), wealthy grandpas would create a generation-skipping trust and transfer appreciated assets to it. The trust would distribute income from its assets to the son or daughter for the rest of their life, with a remainder interest for the grandchildren. The trust might even provide for a distribution of some principal for certain limited purposes. However, the son or daughter would have no power to sell or otherwise dispose of the trust assets.

The interest of the son or daughter was not considered a transfer of property and therefore was not subject to gift or estate tax. Upon the death of the son or daughter, the trust estate would pass to the grandchildren. During the lifetime of the son or daughter, the trust assets would appreciate in value without taxation. 

The GSTT was enacted in 1976 to close the generation-skipping tax loophole. The GSTT tax rate is 40%, but it only applies to the extent the transfer exceeds the Unified Lifetime Exemption.

Lawyers Who Guide You Through Estate Taxation

Federal and state laws regarding the taxation of lifetime and testamentary asset transfers are as tangled as state probate laws themselves.

Many very wealthy people have died without a will. If you have substantial assets, you’ll want the advice and counsel of trust and estate lawyers to navigate the legal complexities.

With or without a will, too many families have experienced sibling disputes when an elder has died without well-planned management of their estate. Avoidable estate and inheritance taxes ultimately are borne by the decedent’s heirs because they diminish the estate assets left to them. 

Unbundled Legal Help works with a nationwide network of attorneys who offer unbundled legal services in addition to traditional full service support. The unbundled approach allows you to affordably engage their services for specific tasks while you work on others. Schedule a free consultation today to discuss your estate planning and probate issues with a lawyer.