Estates are stuck in a morass of complicated rules when it comes to taxation, and the taxes often overlap. The Internal Revenue Service levies an estate tax on the overall value of a decedent's assets and property, and then both the IRS and some states will take a bite of estate disbursements under some circumstances as well.
In addition to estate taxes, a handful of states impose an additional levy called an inheritance tax on specific items of a decedent's property. This tax is payable by beneficiaries when assets pass to them from the decedent's estate in seven states: Indiana, Kentucky, New Jersey, Pennsylvania, Nebraska, Iowa and Maryland. Although Tennessee's statutes include provisions for an "inheritance" tax, it's actually an estate tax – the government does not tax specific bequests or disbursements from the estate. Many beneficiaries are exempt from inheritance taxes because of their relationship to the decedent. For example, spouses typically don't have to pay it, but unrelated individuals or distant relatives usually do.
Most estate disbursements are not subject to income tax, including cash – provided it's bequeathed according to the terms of the decedent's will, through his probate estate. Cash received from a trust is income to the beneficiary, however. When a trust makes disbursements, the trustee must issue a Schedule K-1 to each beneficiary, showing how much was received. The beneficiary must include this income on his personal tax return, and the trust receives a deduction on its income tax return for the same amount.
Income in Respect of a Decedent
Income in respect of a decedent is one of the more complicated aspects of tax law. This is income the decedent earned or was entitled to before his death, but he did not actually receive it before he died. The executor of the estate can include this income on the estate's income tax return, but not on the decedent's final tax return. If the executor doesn't do this, the beneficiary of the income-producing asset must pay taxes on the money. This is usually the case when assets pass directly to a named beneficiary without becoming part of the decedent's probate estate, such as annuities or savings bonds.
Capital Gains Tax
You may be liable for capital gains tax if the decedent's estate disburses property to you and you decide to sell it. Your taxable gain is the difference between what you sold the inheritance for and its fair market value at the time of the decedent's death – you don't also inherit his tax basis, which is whatever he initially paid for the asset. If you sell relatively quickly, before the property appreciates, you might not realize a gain.