When a major event, such as a death in the family, occurs and you are uncertain what the tax implications are, it is best to seek out the expertise of a CPA to help answer your tax questions. “My aunt passed away and left me some money . . . . Is it taxable?” Like most tax questions, that answer depends on several other issues. Usually, the answer is NO. However, there are instances where you will pay income tax on money you receive as an inheritance or tax on the income that the assets you inherited generate.
If Aunt Sally’s will stipulates, “I leave $5,000 to my nephew Johnny,” Johnny will receive $5,000 of cash, and it is NOT taxable to Johnny. This directive is called a “specific bequest.” Aunt Sally wanted to leave Johnny a specific amount of cash. She could have also made a specific bequest of property – “I leave my piano to my niece, Susan.” The piano is also not taxable to Susan.
If Aunt Sally utilizes a residuary bequest her will states, “I leave everything to my nephew, Johnny.” This structure means that Johnny would receive 100% of the residue (or the remainder) of the assets after the estate pays all the expenses and taxes. In the example above, if Aunt Sally only had money, then all of it would go to Johnny, and it is NOT taxable to Johnny (even if it is $20 million!).
If the estate is large enough, it must file a Federal Estate Tax Return. So the ESTATE (not Johnny) is taxed on the excess in the estate over the federal estate tax exclusion ($11.18 million for 2018) less the expenses paid by the estate (for lawyers, accountants, probate, estate debts and administrative costs).
The Federal Estate Tax is 40%, and the Pennsylvania Inheritance Tax differs depending on the relation between the recipient and the decedent. A nephew, like in the example above, or another non-lineal relative, creates a 15% PA tax on the taxable assets (in this case the cash) after expenses. For spouses the rate is 0%, for siblings the rate is 12%, and direct ancestors carry a 4.5% PA tax. So Johnny will receive, not $20 million, but whatever is left – the remainder – after expenses and taxes are paid, but it is still NOT taxable to Johnny for income tax purposes.
Using a different scenario, we will look at a noncash asset. Suppose Aunt Sally owned an IRA and it did not have a beneficiary. The IRA balance would be distributed to the estate, and if the estate’s net income is over $12,500, the estate will end up paying tax on the IRA using the highest individual tax rate (now 37%). This outcome can be mitigated by distributing the proceeds to the beneficiaries of the estate who might be in lower tax brackets.
If the IRA does have a named beneficiary, then the recipient will receive the proceeds from the IRA and a 1099-R for the year of receipt to report the IRA income and any withheld tax on his tax return. There are several options for how the IRA can be distributed depending on your relationship with the decedent/IRA owner and the decedent/IRA owner’s age at the time of death. Therefore, the entire balance may NOT need to be distributed all at once.
If Aunt Sally owned shares of stock or a piece of real estate and left it to Johnny, he would NOT be taxed on the inheritance. In fact, for tax purposes, Johnny’s basis in the stock and the real estate would likely be “stepped up” to the fair market value of the stock and/or real estate as of the date of Aunt Sallie’s death. It is referred to as a “step up” because Aunt Sallie’s basis in the stock may have been $5 per share when she purchased it. Today, the taxable amount for Federal Estate tax and PA Inheritance Tax purposes is the fair market value of the stock at the time of her death, which could be $25 per share. Consequently, Johnny receives that “stepped up” value as his basis on which to calculate any gain or loss when he sells the property himself, rather than Aunt Sally’s $5 per share basis.
So what IS taxable to a beneficiary? Remainder beneficiaries will receive their share of the assets owned at the time of death and the income generated by estate assets until the estate closes. For example, if the estate has $500,000 cash in an interest-bearing account, the remainder beneficiary would pay tax on the interest generated from the time of death until the estate closed. They will receive a Schedule K-1 from the federal Estate income tax return. The beneficiary must report the income from the Schedule K-1 on his or her Form 1040 even though it will not equal the amount of the inheritance nor necessarily agree to any amount received by the beneficiary.
While attorneys typically draft wills and trusts, accountants often help with the tax implications and planning related to estates. If you have questions about the tax implications of an inheritance, a gift, or an estate or trust, contact the Walz Group so we can walk through the necessary steps to achieve the most tax efficient benefits.
By Jamie Provost, CPA, Manager