Understanding Estate Taxes

An estate tax is a tax levied on the entire net asset value of an estate after an individual has died. The estate includes all assets owned by the owner at the time of death, and sometimes assets that have been gifted to others shortly before death. The value of any co-owened assets are allocated among the owners. Assets passing to a surviving spouse are categorically exempt from estate taxes. Both federal and New York estate taxes also have an initial exemption for a certain quantity of assets; this amount increases each year with inflation, and is a highly political issue, subject to major revision when legislative power shifts in elections.

Estate taxes are due nine months from the date of death. The tax is paid, broadly speaking, from whatever liquid assets are available in the estate, though various rules and will provisions can determine the sources of funds more exactly. If there are no, or insufficient, liquid assets in the estate, it is still important to file the estate tax return on time. The penalty for late filing is worse than the penalty for late payment.

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All assets passing to a surviving spouse are exempt from estate taxes. Note that this applies only to a legally married spouse. A quasi-marital relationship absolutely does not count, no matter how long it has lasted -- there is no such thing as common-law marriage for this purpose (or any other purpose in most jurisdictions). Assets passing to formally recognized charitable organizations are exempt. Liabilities and expenses of the estate are also netted-out from the estate's taxable assets -- e.g., legal and accounting fees, funeral expenses, payoff of a mortgage, etc.

Having liquid assets available at the time of death is very important, and they must be assets that are available to the estate itself -- assets that pass to individuals by beneficiary designation, e.g., from a retirement account, will not be available for payment of the tax. It is often necessary to sell illiquid assets, such as real estate, to pay the tax. This can be highly inefficient, both in terms of time and money, and of course can result in the loss of an asset that the family may wish to retain. Life insurance is a time-tested source of funds for estate taxes; a joint-and-survivor policy (aka second-to-die policy) is perfectly suited to the estate tax obligations of a couple who intend to leave everything to one another at the first death, so that estate tax is imposed only at the second death.

There are several simple approaches to minimizing estate taxes, and many complex approaches. The simplest approach is to provide for charitable gifts in one's estate -- this can be written in your will in a manner that shelters the exact amount that would otherwise be taxed, or in any other manner that suits your wishes. Reducing your taxable assets by gifting them to your children, grandchildren or others, can be very effective as well, though this may involve federal gift tax considerations. The more complex approaches often involve trusts -- these can be excellent for large estates and can combine benefits to charities and family members in ways that can be highly customized to your needs and interests.

"Portability" is a feature of the federal estate tax law; it is not a feature of the New York estate tax law. It allows the "unused" portion of one spouse's estate tax exemption to pass to the surviving spouse. So, if the exemption in effect at the time of George's death is $12M, and he uses up $10M of his exemption by bequeathing gifts to non-exempt beneficiaries (i.e., those other than Martha or charities), then he will hvae $2M of "unused" exemption. This passes to Martha. And if, at the time of her death the exemption level is $13M, then she will have a total exemption of $15M. It is Really Important to note that portability is only activated if George's estate tax return (Form 706) is properly filed, with the right box checked. Failure to do this can scuttle the entire benefit.