How the federal estate tax works

The federal estate tax applies to the transfer of a deceased person’s assets to heirs and beneficiaries. The tax is calculated on the decedent’s “gross estate” (all assets owned at death, including real estate, investments, business interests, retirement accounts in some cases, and certain life insurance proceeds) minus allowable deductions (debts, funeral expenses, certain transfers to spouses or charities).

Filing and payment: If an estate’s value exceeds the federal exemption for the year, the executor generally must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, within nine months of death (with a possible six-month extension). The estate must also pay any tax due on the return’s deadline or request a timely extension; unpaid taxes can accrue interest and penalties (IRS — Estate Tax page).

Key caveat: state estate or inheritance taxes
Many states levy their own estate or inheritance taxes with lower exemption thresholds than the federal government. That means a family could owe a state tax even if no federal estate tax is due. Always check your state rules or consult a state tax professional.

(Authoritative source: IRS — Estate Tax: https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax)

Who typically pays the estate tax?

  • The estate itself pays the federal estate tax before assets are distributed; the executor arranges payment from the estate’s liquid assets. Beneficiaries do not directly “pay” the estate tax, but they can receive reduced inheritances.
  • Executors and personal representatives are responsible for filing Form 706 and managing tax-related tasks.
  • If an estate lacks liquidity (e.g., mostly real estate or a business), heirs may need to sell assets or borrow to pay the tax—this is a common planning problem.

In practice: In my experience advising clients, the biggest surprise is liquidity. A $10 million estate that’s 90% tied up in a family business or farmland can create a cash crunch for paying estate tax even if the total tax due is modest.

Current exemption and inflation adjustments (check IRS for the latest amount)

The federal unified estate and gift tax exemption is indexed for inflation and has risen materially in recent years. For reference, recent years saw exemptions in the multiple-million-dollar range; the Tax Cuts and Jobs Act doubled the basic exclusion amount through 2025 but that higher level is scheduled to sunset unless Congress acts. Because this number changes annually, use the IRS estate tax pages or consult a tax advisor for the current exemption and the exact exemption that applies to a specific decedent.

Common planning tools to reduce estate tax exposure

1) Annual exclusion gifts

  • You can gift a fixed amount per recipient each year without using any of your lifetime exemption. This reduces the size of your taxable estate while transferring wealth during life. (For recent years the exclusion has been in the high-teens per recipient annually; confirm current amount with the IRS.)

2) Lifetime gifting and the unified credit

  • Large lifetime gifts use part of your federal unified credit (the same pool that shelters estate tax). A formal gift tax return (Form 709) documents these gifts.

3) Trusts

4) Portability for married couples

  • Portability allows a surviving spouse to use any unused portion of a deceased spouse’s federal exemption by filing an estate tax return that elects portability. This can be powerful but it requires an affirmative election (timely Form 706) to preserve that unused exemption.

5) Life insurance planning

  • Life insurance proceeds are generally income-tax-free to beneficiaries but can be included in the insured’s taxable estate if the insured retained incidents of ownership. Placing a policy in an ILIT keeps proceeds out of the estate while preserving liquidity for estate taxes or equitable distributions. For practical pitfalls on life insurance in estate plans, see our article: Life Insurance in Estate Plans: Uses and Pitfalls.

6) Business succession and valuation discounts

  • Closely held businesses can be transferred using valuation discounts, family limited partnerships, or sales to intentionally defective grantor trusts (IDGTs) to shift future appreciation out of the estate. These strategies require solid documentation, appraisals, and compliance with IRS valuation rules.

7) Charitable strategies

  • Charitable remainder trusts, charitable lead trusts, or direct bequests reduce estate tax while supporting causes you care about. Large charitable gifts also create estate tax deductions, lowering taxable estate value.

Practical planning checklist (step-by-step)

  1. Inventory assets and ownership titles (retirement accounts, brokerage, real estate, business interests).
  2. Get up-to-date valuations for material assets, especially businesses and real estate.
  3. Confirm beneficiary designations on retirement plans and life insurance — these often bypass probate but can affect estate tax calculations.
  4. Evaluate liquidity: can the estate pay taxes without forced sales?
  5. Consider lifetime gifting (annual exclusions, direct tuition/medical payments) and whether to use more advanced trusts.
  6. For married couples, decide whether to file for portability when one spouse dies.
  7. Coordinate with estate counsel and a CPA experienced in estate taxation; complex strategies require legal and tax review.

In my practice, following a local valuation and a liquidity plan (often life insurance held outside the estate) prevents the most common executor crisis: needing to sell the family business at distress prices to raise cash.

Common mistakes and misconceptions

  • “I don’t need a plan because I’m not that wealthy.” Many people underestimate the value of all assets combined. State estate taxes and business valuations can surprise families.
  • Forgetting portability. If the executor doesn’t timely elect portability, the surviving spouse may lose valuable exemption.
  • Relying on beneficiary designations alone. Retirement accounts may carry income tax consequences even if not estate-taxable and can dramatically change net inheritances.
  • Leaving life insurance owned in your personal name without an ILIT; that can inadvertently pull proceeds back into the taxable estate.

When to use which technique (rules of thumb)

  • If your estate is far below the federal exemption and not illiquid, keep plans simple: wills, beneficiary designations, and basic trusts for incapacity.
  • If your estate nears or exceeds federal or state thresholds, consider a layered approach: lifetime gifts, ILITs, business succession planning, GRATs, and charitable vehicles.
  • If you own a closely held business, prioritize valuation, succession, and liquidity planning before advanced gifting.

Frequently asked practical questions

  • Who pays the tax? The estate pays federal estate tax before assets are distributed to heirs; the executor is responsible for filing and payment.
  • Can I avoid estate tax entirely? Complete avoidance is difficult for very large estates; the goal of planning is usually to reduce, shift, or provide liquidity to pay taxes without forced sales.
  • Do beneficiaries pay income tax on inheritances? Generally, inherited property receives a stepped-up basis for capital gains (at federal level) but retirement accounts distributed to heirs can generate income tax. Coordinate with a tax advisor.

Action items and next steps

  1. Run a current net-worth statement including realistic valuations and liquidity analysis.
  2. Meet with an estate attorney and CPA to discuss portability, ILITs, GRATs, or charitable planning if your estate approaches applicable thresholds.
  3. Keep documents current after major life events.

For implementation guidance on funding trusts and practical steps to keep assets aligned with intended distributions, see our practical guide: Trust Funding Roadmap: Ensuring Assets Follow Your Intentions.

Sources and further reading

Professional disclaimer: This article is educational and does not replace personalized tax, legal, or financial advice. Complex estate-tax planning strategies should be implemented only after consultation with qualified estate attorneys and tax advisors experienced in federal and state rules.