Core Principles of Estate Planning and Taxation

Estate planning is the process of creating a clear plan for managing and transferring your assets after death. This ensures your wishes are carried out, providing for loved ones or supporting charitable causes. A significant part of this planning involves navigating federal and state taxes, as these liabilities can diminish an estate’s value. The goal is to use available legal structures to organize your financial affairs efficiently, preserving asset value and ensuring a smooth transition of wealth.

Core Taxes Affecting Estates

Federal Estate Tax

The federal estate tax is a tax on the transfer of a person’s property after their death. The tax is calculated on the value of the “taxable estate,” and the responsibility for payment falls on the estate itself before any assets are distributed to heirs. Only a small percentage of estates in the United States are subject to this tax due to a significant exemption amount provided by the Internal Revenue Service (IRS).

For 2025, the federal estate tax exemption is $13.99 million per individual. An individual can pass away with assets valued up to this amount without incurring any federal estate tax. For a married couple, this exemption is effectively doubled to $27.98 million. If an estate’s value exceeds this threshold, the portion above the exemption amount is taxed at a rate of up to 40%.

This exemption amount is subject to change. Under current law, the increased exemption is scheduled to expire at the end of 2025. Without new legislation, the exemption will revert to its pre-2018 level of approximately $5 million, adjusted for inflation, in 2026. This potential change underscores the importance of long-term planning.

Federal Gift Tax

The federal gift tax is linked to the estate tax and is designed to prevent individuals from avoiding estate taxes by giving away all their assets before death. It applies to the transfer of property to another person without receiving something of at least equal value in return. The tax system provides an annual exclusion, which allows individuals to give a certain amount to any number of people each year without tax implications.

For 2025, the annual gift tax exclusion is $19,000 per recipient. A married couple can combine their annual exclusions to give up to $38,000 to a single recipient. Gifts exceeding this annual amount must be reported to the IRS on Form 709. Any amount gifted above the annual exclusion is subtracted from the individual’s lifetime gift and estate tax exemption, the same $13.99 million exemption that applies to estates. A gift tax is only due if an individual’s cumulative taxable gifts exceed the lifetime exemption amount.

State-Level Taxes

In addition to federal taxes, some states impose their own taxes on estates or inheritances, and their rules can differ from federal regulations. A state estate tax is levied on the total value of the decedent’s estate before assets are distributed. The exemption amounts for state estate taxes are often much lower than the federal exemption, meaning more estates may be subject to a state-level tax.

An inheritance tax is paid by the beneficiaries who receive the property. The tax rate often depends on the heir’s relationship to the decedent. Spouses are exempt, and close relatives may face lower tax rates than more distant relatives. The laws of the state where the decedent lived determine which, if any, of these taxes apply.

Calculating the Taxable Estate

Determine the Gross Estate

The first step in calculating potential estate tax liability is to determine the value of the gross estate. This is a comprehensive accounting of all property and assets the decedent owned or had an interest in at the time of their death. Assets are valued at their fair market value on the date of death. The executor can sometimes elect to use an alternate valuation date, which is six months after the date of death.

The gross estate is broad in scope and includes:

• Cash in checking and savings accounts
• Securities like stocks and bonds
• All real estate holdings
• Business interests
• Vehicles and valuable personal property like art or jewelry
• Retirement accounts
• Death benefits from life insurance policies owned by the decedent

Subtract Allowable Deductions

Once the gross estate is valued, the next step is to subtract certain allowable expenses and debts to arrive at the adjusted gross estate. Common deductions include any outstanding debts of the decedent, such as mortgages and credit card balances. Deductible costs also include funeral expenses and administrative fees for settling the estate, such as executor commissions, attorney’s fees, and court costs.

Apply Major Deductions

After subtracting initial debts and expenses, two significant deductions can further reduce the estate’s value. The first is the unlimited marital deduction, which allows for the unlimited transfer of assets from a deceased individual to their surviving U.S. citizen spouse without incurring any estate tax. This defers any potential estate tax until the death of the second spouse.

The second major deduction is the unlimited charitable deduction. Any assets left to a qualified charitable organization, such as one defined under Section 501(c)(3) of the Internal Revenue Code, are fully deductible from the estate. There is no limit to the amount that can be deducted for charitable contributions.

Final Calculation

The taxable estate is determined by subtracting all allowable deductions from the gross estate. If this final value is less than the federal exemption amount for the year of death, no federal estate tax is owed.

Key Estate Planning Strategies to Manage Taxation

Strategic Gifting

One of the most direct ways to manage the size of a taxable estate is through strategic gifting. By using the annual gift tax exclusion, an individual can transfer significant wealth over time without reducing their lifetime gift and estate tax exemption. These gifts remove the assets, plus any future appreciation, from the donor’s estate.

For example, a couple with three children and five grandchildren could transfer $304,000 per year to their family members completely tax-free. In addition to the annual exclusion, direct payments made for someone else’s tuition or medical expenses are also exempt from the gift tax. These payments must be made directly to the educational institution or medical provider to qualify.

Establishing Trusts

Trusts are legal tools that hold and manage assets on behalf of beneficiaries, offering control and potential tax advantages. Certain irrevocable trusts are useful because they can remove assets from the grantor’s gross estate. Once assets are transferred to an irrevocable trust, the grantor relinquishes control, and the trust becomes a separate legal entity.

Irrevocable Life Insurance Trust (ILIT)

An ILIT is designed to own a life insurance policy. When the trust owns the policy, the death benefit is paid to the trust, keeping the proceeds out of the gross estate and free from estate tax. If an existing policy is transferred to an ILIT, the grantor must survive for three years after the transfer for the proceeds to be excluded from their estate.

Grantor Retained Annuity Trust (GRAT)

A GRAT allows a grantor to transfer assets into a trust for a fixed term while receiving an annuity payment. If the trust’s assets grow faster than an IRS-set interest rate, known as the Section 7520 rate, the excess growth passes to beneficiaries with minimal or no gift or estate tax. GRATs are well-suited for assets expected to appreciate significantly.

Charitable Trusts

A Charitable Remainder Trust (CRT) allows a grantor to transfer assets to a trust, receive an income stream for a set period, and have the remaining assets go to a designated charity. This provides the grantor with an income tax deduction when the trust is funded and removes the asset from their estate. A Charitable Lead Trust (CLT) makes payments to a charity for a set term, with the remaining assets eventually passing to non-charitable beneficiaries at a reduced tax cost.

Understanding Portability

Portability is a provision in federal tax law that allows a surviving spouse to use any of their deceased spouse’s unused federal estate tax exemption. This unused portion is known as the Deceased Spousal Unused Exclusion (DSUE) amount. For example, if a husband dies in 2025 having used only $9 million of his $13.99 million exemption, his surviving wife can add the unused $4.99 million to her own exemption.

Portability is not automatic and must be elected by the executor of the first-to-die spouse’s estate. This provides flexibility and a safeguard against future changes in tax law or unexpected appreciation of assets. Portability does not apply to the generation-skipping transfer (GST) tax exemption or to state estate tax exemptions.

The Estate Tax Filing Process

The Required Form and Filing Responsibility

When an estate’s value exceeds the federal exemption, or when electing portability, the executor must file IRS Form 706, the United States Estate Tax Return. This form requires a detailed accounting of the decedent’s assets, deductions, and the calculation of any tax due. Due to its complexity, preparation is handled by a qualified attorney or CPA.

The legal responsibility for filing Form 706 and paying any tax falls to the executor of the will. If there is no will, the court appoints an administrator. The executor is personally liable for the accuracy of the return and the payment of the tax, so careful work is required to ensure all legal requirements are met.

Deadlines and Extensions

The deadline for filing Form 706 and paying any estate tax is nine months after the decedent’s date of death. An automatic six-month filing extension can be requested on or before the original deadline.

An extension to file is not an extension to pay. If the estate is expected to owe taxes, an estimate of the tax due must be paid with the extension request. If the tax is not paid by the original nine-month deadline, interest and penalties will begin to accrue on the unpaid balance.

Making the Portability Election

The formal action to secure a deceased spouse’s unused exemption is to make the portability election on a complete and timely Form 706. The executor must make this election, even if the estate’s value is below the standard filing threshold and no tax is due.

The IRS has provided a simplified method to obtain an extension for making the portability election. Under Revenue Procedure 2022-32, an estate not otherwise required to file can do so to elect portability up to five years after the decedent’s death. To use this relief, the executor must write a specific statement on the top of the Form 706.