IRS Form 706: Understanding Estate and Gift Taxes

If you have ever heard of the “death tax,” you’ve heard of the estate tax. Yet, despite the media coverage it has seen over the years, the federal estate tax is one most Americans will never have to worry about. However, if you have to worry about it, it’s important to understand gift and estate taxes and familiarize yourself with Form 706. Out of 2.7 million recorded deaths in 2016, only 5500 decedent taxpayers had to pay an estate tax on their estates.

That makes up about 0.2 percent of estates for that year. Meanwhile, only about 2000 taxpayers ended up paying any gift tax in 2018, another rare tax most taxpayers never need to worry about. But that doesn’t change the IRS’ filing requirements around estate taxes – nor does it change the fact that, while estate taxes remain rare, they may be less rare soon.

What Are Estate Taxes?

The IRS imposes estate taxes on the taxable wealth a person leaves behind when they die. An estate tax is a wealth tax imposed on estates with a total value above the exemption limit, which is currently at $12.06 million per individual in 2022. The tax rate on estates of over $12.06 million varies depending on how much additional wealth an estate has, capping at 40 percent. If you are married, you and your spouse can utilize a specially structured trust called an AB trust. An AB trust takes advantage of your joint tax exemption limit, finalizing a $24.12 million exemption limit on your combined estates if you both pass away this year.

When Are Estate Taxes and Form 706 Relevant to You?

Estate taxes are applied to an estate after a person has died. This means they are not something you will personally worry about until you have died. However, you may worry about how estate taxes affect your children’s inheritance. If you have a substantial amount of wealth to leave behind, looking for ways to limit your total taxable estate can ensure that you do not impose any significant tax liabilities on the wealth you leave behind for your family. The estate tax exemption limit is adjusted each year for inflation.

Much has changed over the years regarding the estate tax. Its exemption limits were much smaller, and its top marginal tax rate was as high as 55 percent just 20 years ago, as opposed to 40 percent today. The last significant change it underwent was in 2017 when the Tax Cuts and Jobs Act effectively doubled the basis for the estate tax exemption limit from about $5 million to $10 million. The current administration may seek to reverse that change or tackle changes made to the estate tax exemption over the past few years. The estate tax exemption limit will reverse in 2026 automatically.

What Are Gift Taxes?

The IRS imposes gift taxes on all gifts made yearly, exceeding the annual gift tax exemption limit. The federal gift tax exemption limit is $15,000 in 2022 or $30,000 if filing jointly as a married couple. If you exceed $30,000 in gifts this year, you will owe a gift tax. However, you do not need to pay this tax – at least, not initially. You can defer all gift tax liability incurred over your lifetime onto your estate tax exemption limit.

If you have incurred a tax liability on roughly $100,000 worth of gifts made past your annual limit over multiple decades, then you can shave off $100,000 off your estate tax exemption limit. Instead of an exemption limit of $12.06 million, you may have an exemption limit of $11.96 million. This is why the estate tax exemption limit is also known as the lifetime gift tax exemption limit. The gift tax and the estate tax share this limit. This means wealthy individuals who make massive contributions to friends and family significantly eat into the exemption limit they leave themselves at the end of their life.

Do I Need to File Form 706?

As mentioned previously, very few taxpayers need to worry about the IRS’ federal estate tax. However, you might still need to file Form 706. Or at least, someone will. This is a posthumous tax return, meaning it isn’t one you can file for yourself. Your loved ones or lawyer must file a Form 706 in the months after your death to calculate how much estate tax and gift taxes your estate owes before officials can distribute it among your beneficiaries through the probate process. This will usually be part of their responsibilities if you have an executor assigned to your estate via your will.

If you are managing your estate primarily via trusts, it may be the responsibility of your successor trustee. Even if your estate is far below the exemption limit on estate taxes now, this can change over time. As the exemption limit decreases, the number of taxpayers qualifying for Form 706 increases. However, hitting the exemption limit does not necessarily mean that your estate will assuredly pay taxes. There are other deductions the IRS may apply before they can calculate estate taxes. In turn, any gifts made above the annual exemption limit will eat away at your estate tax exemption limit.

When to File Form 706 for an Estate Tax Return?

The fiduciary responsible for your financial and tax-related affairs after death must file a Form 706 in the months after your death, with a time limit of nine months.

Estate Taxes vs. Inheritance Taxes

Federal estate taxes are the domain of the IRS, while state estate taxes are each state’s business. Not all states impose an estate tax, and some states that previously did – like California – have since gotten rid of their estate tax. However, state tax law is subject to change, just like federal law. States with an estate tax today might not have one tomorrow, and vice versa.

Inheritance taxes are additional taxes applied on wealth beyond an exemption limit when it transfers into the hands of beneficiaries. An estate can be taxed once a person dies and again when an inheritance is bequeathed to an heir. Inheritance taxes are not to be confused with state taxes. These are separate taxes only levied by some states.

Estate Taxes, Gift Taxes, and Estate Planning

Keeping track of exemption limit changes, tax law changes, and the different filing requirements you need to consider for your family after you’re gone can be challenging. Hiring a tax professional with estate planning knowledge can come in handy. Tax considerations are essential to planning your estate. This ranges from writing your will to formulating beneficiary designations, making gifts, and creating trusts.