Inheritance and Estate Taxes Can Impact Ordinary Taxpayers, Too

The news that King Charles III will not have to pay tax on assets that he inherits is making headlines this week. Some of the chatter suggests that a full tax exemption is a perk of being royal, while others have claimed that no exemptions apply to more ordinary taxpayers. Both premises are wrong.

It is true that King Charles will not have to pay inheritance tax on certain assets he inherited from his mother as a result of an understanding reached between the Royal Family and Inland Revenue in 1993. A 2013 memorandum of understanding further clarified and expanded the agreement, making clear two things:

1. Assets owned by the monarchy are not subject to inheritance tax; and
2. Certain assets that are considered private but also have an official use—such as Balmoral, a Scottish residence belonging to the royal family—and will pass from one Sovereign to the next, will not be subject to inheritance tax. (If those assets passed to anyone else, the exemption would not apply.)

UK Inheritance Tax

Outside the royal family, UK residents and taxpayers who own UK property subject to tax ordinarily would pay a 40% tax on assets exceeding the £325,000 exemption amount—a reduced rate applies if you leave certain assets to charity. Some special rules and exemptions may also apply—this is tax law, after all.

Prince Charles, Prince Of Wales attends day one of Royal Ascot at Ascot Racecourse on June 18, 2013, in Ascot, England.

Photographer: Stuart C. Wilson/Getty Images for Ascot Racecourse

Federal Estate Tax

While we don’t have an exception for royalty in the US, we do have a king-sized exclusion available: The federal estate tax exemption in 2022 is $12,060,000 per person or $24,120,000 per married couple.

Here’s how that works.

US taxpayers are generally subject to tax on assets in their own name or assets they control, including property outside the country. Your assets might include financial interests such as cash, bonds, and stocks, as well as real estate, business interests, insurance proceeds, art, and collections. Deductions, including your debts and expenses relating to the administration of your estate, are netted against your assets on Form 706, and the result is what’s referred to as your taxable estate.

Taxable Gifts

Here’s where things get tricky. When calculating the value of your estate, you add back in the value of lifetime taxable gifts—beginning with gifts made in 1977.

Taxable gifts are those gifts that exceed the annual exclusion amount. For 2022, that amount is $16,000. That means you can make a gift of up to $16,000 per person in 2022 without being subject to gift tax. It’s worth noting that you can make unlimited gifts to US citizen spouses. But what if you give a gift of $100,000 to someone other than your spouse? That $84,000 overage is a taxable gift, typically reportable on Form 709.

But even if you make a taxable gift, you don’t have to whip out your checkbook. Realistically, most taxpayers don’t pay gift tax. Any lifetime taxable gifts merely chip away at that federal estate tax exemption amount. To figure out how that affects your estate, you’ll effectively add those taxable gifts back into your estate.

Figuring the Tax

This is the part that gives taxpayers and professionals alike fits. When you’re figuring the tax, technically, you calculate the tentative tax due and then back out the applicable credit amount. That credit is equal to the tax on the applicable exclusion amount.

That’s a lot of math. That’s why, as a rule of thumb, you simply can use the federal estate tax exemption amount each year to figure whether you would be subject to tax. Spoiler alert: Most taxpayers are not, and most estates are not even required to file an estate tax return.

Federal Estate Tax Return Data

In 2020, the last tax year for which complete data is available, just 3,441 federal estate tax returns were filed. More than half were nontaxable returns. That would include returns where assets passed to charity or spouses, resulting in no tax, and where returns were required to be filed, but no tax was due.

Additionally, some returns are filed as elections, not for purposes of paying tax. That’s because, beginning in 2011, the IRS announced married decedents could pass along the unused part of their exclusion amount—rather than waste it—to the surviving spouse by timely filing a Form 706.

Since federal estate tax returns are due nine months after the date of death, most returns filed in 2020 were for decedents who died in the previous year. In 2019, there were 2,854,838 reported deaths in the US. The difference in those numbers—returns filed compared to deaths—is significant.

The number of federal estate tax returns expected to be filed likely will continue to dip as the exemptions continue to rise. Experts expect the exemption amount to increase to about $13.1 million by 2025 (assuming 3% inflation in each of the next three years, which feels like a bold assumption) and then drop to about $6.8 million in 2026. The drop is because Congress only temporarily boosted the exemption amount in 2018. It will sunset back to the 2017 level of $5 million, adjusted for inflation.

And if your mind is clicking back to the earlier description of the estate tax calculation, you may be wondering how the estate tax will apply to gifts that were made before the drop. The IRS has clarified that taxpayers who take advantage of the 2018 to 2025 exclusion amounts can do so without worrying that they’ll lose the benefit of the tax-free transfer. According to the Final Regulations, the estate can calculate the credit using the higher of the base exclusion amount applicable to gifts made during lifetime or the base exclusion amount applicable on the date of death.

Inheritance and Estate Taxes

Taxpayers who escape federal estate tax at death—remember, that’s most of us—may still have one hurdle to clear: inheritance and estate taxes at the state or district level.

What’s the difference? Generally, an estate tax is a tax on the right to transfer property at death. An inheritance tax is a tax on the right to receive property at death. Some states—such as New Jersey—used to have both. Currently, only Maryland charges an inheritance and an estate tax.

In addition to Maryland, five states have an inheritance tax: Iowa, Kentucky, Nebraska, New Jersey, and my own state of Pennsylvania. In most cases, property that passes to a spouse is exempt from inheritance tax. Some states also exempt inheritances to children or tax them at a lower rate.

Eleven states—Connecticut, Hawaii, Illinois, Maine, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington—plus the District of Columbia impose an estate tax.

Tax Planning

So, how do you get around paying these taxes? Barring any arrangements to exempt you from tax—we won’t all get the royal treatment—there are steps you can take to reduce or eliminate the amounts due. But keep a few things in mind:

• Pay attention to the source. Just because something is widely shared on social media doesn’t make it true. For example, transferring personal assets to a business or revocable trust typically won’t make them exempt from tax.
• Know the differences between federal and state rules. For example, life insurance is generally taxable for federal purposes but may be exempt for state purposes.
• Understand the terminology. Probate assets are those that pass via your will. Making your assets nonprobate won’t necessarily make them nontaxable.
• Do the math. Tax planning is smart, but don’t get so blinded by the idea of saving tax that you lose money in the process. Paying to create an entity to shield assets from tax might make sense for some taxpayers, but for others, it could be more expensive to set up than to pay the potential tax.
• Think about your lifestyle. Retitling assets or otherwise giving up control of assets simply to avoid tax can create problems during your lifetime. Make sure that the reward is worth any risk.
• Ask questions. If large chunks of this article made your head hurt, don’t turn to Google. Ask a professional for help. A trustworthy professional will look at your assets and individual circumstances and then craft a plan that works best for you.

This is a regular column from Kelly Phillips Erb, the Taxgirl. Erb offers commentary on the latest in tax news, tax law, and tax policy. Look for Erb’s column every week from Bloomberg Tax and follow her on Twitter at @taxgirl.