My client received an inheritance

Inheritance can be a double-edged sword. On the one hand, inherited assets are often welcome. But it’s usually at the cost of losing a loved one. Amid the emotional and logistical burdens, the boost in net worth may be the last thing on your client’s mind.

Once a client emerges from the emotional haze of a death in the family to focus on the practical aspects of inheritance, one of the first calls made will be to a financial advisor. Or you may hear from the spouse or child of a recently deceased client who has left an inheritance. Along with condolences and support to navigate this new normal, you can offer guidance to help your client understand the implications of an inheritance to personal and family finances and raise important and time-sensitive considerations to discuss with an estate planning attorney or tax professional. Even for those who expect to receive an inheritance in the future, providing answers to the following essential questions can help your client through this initial stage of discovery.

Will the inheritance be received outright or in trust?

People who receive an inheritance often don’t know the answer to this basic question — or even where to find it. The answer to whether the inheritance will be made directly or in trust is in the estate plan documents, which should be held by the executor or trustee. If the client is not the named executor or trustee, she can request a copy of the operative documents from that person and have them reviewed by an estate planning attorney. An estate planner can advise on the structure of the inheritance, the terms of any continuing trust and the implications on the client’s control over the investment, management and distribution of the assets.

Note that certain assets, such as retirement assets and insurance policies, are inherited through beneficiary designations and would generally not be included in the will or living trust.

What are the tax aspects of the inheritance? 

Once the assets either belong to the client or are being held for the client’s benefit in an ongoing trust, taxes on the inherited property may impact individual tax planning. Here are some tax issues the client should be aware of:

• If the assets are held in a continuing trust, are they exempt from the GST tax?
  A generation-skipping transfer (GST) occurs when assets transfer to someone two or more generations below the donor. When those assets exceed a certain, substantial amount, a GST tax is imposed. If assets are GST exempt, depending on which generation the client belongs to, this may impact the likelihood and suitability of receiving distributions from the trust.
  
  
• What’s the income tax basis (and is there evidence)?
  If the inheritance comes in the form of appreciated assets, such as stocks, the client’s income tax basis in the assets will be “stepped up” to the fair market value of the assets upon the decedent’s death. This is a tremendous tax benefit, particularly for a client who inherits a low-basis asset. A stepped-up basis for the client means that if she were to sell the asset immediately after the decedent’s death, there would be little, if any, income tax due. The client should maintain a record of the new basis along with the evidence establishing this basis. The best source for this information is the acting executor or trustee.
  
  
• Are there income tax consequences?
  The client is not subject to income tax just because she inherits the assets. Depending on the type of assets she inherits, however, there may be future income tax events to consider. For example, if the client inherits an asset that regularly generates ordinary income or dividends, this may impact her tax bracket or prevent her from benefiting from certain deductions or credits. Or if the client inherits an interest in an LLC or a partnership, she may be forced to contend with phantom income, which is an income tax liability without the accompanying receipt of funds to pay it.
  
  
• If the inherited assets are held in a continuing trust, who’s paying the taxes?
  The client should understand who will need to pay the taxes on the income earned by the trust assets: the client or the trust. Responsibility depends on the terms and structure of the trust, so it’s important to address these issues with an estate planning attorney.
  
  
• Does the client need the assets, or does it make more sense to disclaim them?
  Disclaiming an inheritance means giving up any interest in the assets that are the subject of the inheritance. If a client does so in an appropriate manner and time frame, she should not be treated as the owner of the assets for tax purposes. Instead, the assets will pass to the beneficiary next in line under the decedent’s estate plan documents.
  
  For tax reasons, a disclaimer may be utilized. However, for a disclaimer to produce the desired tax effects, it must meet certain strict requirements. Notably, the disclaimer must be made within nine months of the client becoming entitled to the assets. For this reason, it’s essential to address a potential disclaimer as soon as practicable after the decedent’s death.

A disclaimer explainer

Why would anyone want to give up an inheritance? Disclaiming a gift may be an option to consider for a few reasons:

Passing the gift to the next person in line. For example, a parent may disclaim an inheritance so it might be passed along to a child, a wealthy sibling may pass their inheritance along to a less well-off sibling, and so on.

Reducing the size of the estate. The estate tax exemption is more than $11.5 million until 2025. A client with an estate of that value or more may be concerned about future taxes and pass the inheritance to the next beneficiary instead.

Adjusting the intended gift. If the inheritance doesn’t quite fit the intentions of the deceased, a disclaimer can help make things right. For example, a certain amount may have been named to the deceased’s children assuming the surviving spouse or contingent beneficiary is provided for. If a change in financial circumstances puts the surviving spouse at risk, a client may choose to disclaim and let the assets pass on to the spouse.

How does inheritance impact my client’s financial plan and estate plan?

If a client receives a substantial inheritance, it is imperative that she review her estate plan with an attorney — and if the client doesn’t have an estate plan, it’s time to put one in place. A dramatic increase in the client’s net worth means a corresponding increase in her potential taxable estate upon death. That means the terms of the client’s will or trust may need to be restructured to mitigate transfer taxes at death.

Additionally, now that the client has more assets to leave her own beneficiaries, she may want to review who her beneficiaries are, how much they’ll receive and how they’ll receive it. For example, the client may have been comfortable with each of her children receiving $1 million outright upon her death, but those feelings may change if the amount were to increase fivefold. In that case, adding continuing trusts for children under the estate plan documents could be a possible solution.

Start the conversation about inheritance

If you have a client who has recently lost a loved one, consider reaching out to offer your sympathy and assistance. As your client’s trusted advisor, you can help prepare her for the financial complexity that may lie ahead. By asking the right questions, you’ll demonstrate the importance of obtaining expert advice. You can then steer your client to estate planning attorneys, accountants or other professionals who will help her understand her rights and obligations as a beneficiary and guide her through the appropriate planning. You’ll benefit your client while cementing your role in her advisory team and strengthening your own professional network. 

Inheritance checklist

When meeting with a client who is preparing to receive an inheritance, this checklist can help identify relevant financial and estate planning considerations or download our Preparing for an inheritance: Discussion checklist to use with clients.

How is the inheritance structured?

• Outright or in trust
• Terms of continuing trusts
• Control over investments and distributions
  

What are the tax aspects of the inheritance?

• Generation-skipping transfer (GST) tax
• Income tax basis
• Future income tax consequences
  
• Responsibility for taxes on trust income
  

Is a disclaimer of assets being considered?

• Strict requirements
• Time sensitive
  

What is the effect of inheritance on the estate plan?

• Taxability of the estate
• Is inheritance structured outright or in trust
  

Further, depending on her life stage and net worth prior to the inheritance, the client may want to consider gifting assets to lower generations to decrease the size of her taxable estate.