Inheritance Tax

An inheritance tax is a tax imposed by a state on a person who receives property because its owner died. The defining feature is who owes it: the beneficiary, measured on their own share, at a rate and exemption that depend on their relationship to the decedent. An estate tax, by contrast, is computed on the whole estate before anything is distributed and does not care who the beneficiaries are.

The two are separate taxes rather than alternative labels for one tax. A state can levy an estate tax, an inheritance tax, both, or neither, and at least one state does levy both. Only a minority of states impose an inheritance tax at all, and the list changes as legislatures repeal or phase them out, so the reliable source is the revenue department of the decedent's state rather than any national summary.

There is no federal inheritance tax, and the positive version of that statement is more useful than the negative one. Federal transfer taxes fall on the estate under chapter 11, on the giver under chapter 12, and on generation-skipping transfers under chapter 13. None of them is imposed on a recipient for receiving property. Going further, Internal Revenue Code section 102(a) provides that "gross income does not include the value of property acquired by gift, bequest, devise, or inheritance", so an inheritance is not federal income either. Income the property later produces is taxable in the ordinary way, but the receipt itself is not.

Whose state matters is the question these taxes are most often lost on. An inheritance tax generally follows the decedent's domicile, together with real property physically located in the taxing state. So an heir living hundreds of miles away in a state with no such tax can still owe it on a bequest from a relative who lived in a state that has one, and an heir living in a taxing state generally owes nothing on a bequest from a decedent who lived elsewhere. Moving after the death changes nothing.

The class structure is the design, not a detail. Where the tax exists it is typically built as a set of relationship classes, each with its own exemption and its own rate schedule. A surviving spouse is generally exempt. Beyond that, generalizing is unsafe: at least one state taxes direct descendants at a positive rate, and rates for siblings, nieces and nephews, and unrelated beneficiaries usually step up sharply. The practical consequence is that two people inheriting identical amounts from the same estate can owe very different tax.

Who actually files is not always who owes. The beneficiary is the taxpayer, but in practice the estate's executor or the financial institution frequently files the return and withholds the tax from the distribution. Deadlines are set by the state and do not track the federal estate tax's nine months. Some states discount the tax for paying within a few months of the death, and interest runs once a return becomes delinquent. The tax can also attach as a lien on real property, which is why a title company asks for a release before a sale closes.

It reaches beyond probate. Assets that pass outside a will, including jointly held property, payable-on-death and transfer-on-death accounts, and in some states certain life insurance and retirement accounts, are commonly within an inheritance tax's reach even though they never touch the probate estate. Avoiding probate and avoiding inheritance tax are two different projects, and the planning that achieves the first frequently does nothing for the second.

The executor identifies the property passing to each beneficiary, including non-probate transfers, sorts the beneficiaries into the state's relationship classes, applies each class's exemption and rate, and files a return with the state. Tax is usually paid out of the relevant share, so beneficiaries in exempt classes are unaffected by what other beneficiaries owe.

A hypothetical, using invented classes and rates. No state's actual schedule is reproduced here, and the numbers exist only to show the shape.

Suppose a state exempts a surviving spouse entirely, taxes a sibling's share above a $25,000 exemption at 10%, and taxes an unrelated beneficiary's share above $500 at 15%. A decedent leaves $200,000 to be split equally between a sister and a friend. The sister receives $100,000, subtracts her $25,000 exemption and owes 10% of $75,000, which is $7,500. The friend receives the same $100,000, subtracts $500 and owes 15% of $99,500, which is $14,925. Identical bequests, and nearly twice the tax on one of them, purely because of the relationship.

Note also what the example does not include: the sister and the friend each take the property with a basis stepped up to its date-of-death value for federal income tax purposes, and any inheritance tax they pay does not change that basis.

Pros

• Because it is measured share by share, an heir in an exempt class pays nothing regardless of the size of the estate.
• Exemptions are set per beneficiary, so splitting an estate among several people can reduce the total tax where the classes allow it.
• No federal inheritance tax exists, and section 102(a) keeps the receipt out of federal income entirely.
• Some states discount the tax for early payment.

Cons

• It is charged to the person receiving the money, often at a point when they are least equipped to deal with it.
• It follows the decedent's state, so an heir can owe tax to a state they have never lived in.
• Deadlines and interest are set by the state, so a beneficiary who does not know the tax exists can miss both.
• It commonly reaches joint accounts and beneficiary designations, so avoiding probate does not avoid the tax.
• The tax can be a lien on real property, complicating a sale.
• Distant relatives and unrelated beneficiaries, including unmarried partners in states that do not recognize the relationship, face the highest rates.