Hello again Cadillac,
There is no longer any inheritance tax or estate taxes in California, so state filings are not an issue.
For federal purposes, it may depend on when your wife's sister actually passes away. For the year 2010, the estate tax has been eliminated entirely. It is set to return in 2011 and will apply to any estate with a value of $1 million or more. If her estate does not exceed $1 million, then again you will have no estate filings to worry about. If she does pass away in 2011 and her estate is valued at more than $1 million, you will need to file an estate tax return and pay estate taxes on the portion of her estate which exceeds the $1 million exemption at a rate of 55%.
If it ends up that her estate is not subject to estate tax or whatever is left after the estate taxes are paid, that will be the end of your tax liability. If your wife plans to give her share of the inheritance ($500,000) to her sons, then she will need to file a gift tax return to report the amount she gave them, but no taxes would likely be due.
Under current law, each taxpayer is allowed to give gifts in their lifetime of up to $1 million before they pay any gift taxes. There is also an annual exclusion on gifts of $13,000 to another individual which do not even apply towards this lifetime exemption. But gifts that exceed the $13,000 annual gift exclusion must be reported by filing Form 709 with the IRS. Those gifts then reduce the person's remaining lifetime limit down from the $1 million tax free limit. So your wife would file the form 709 to report the $500,000 she would be giving in gifts to her sons.
If no estate taxes apply or once estate taxes have been paid, the heirs have no further taxes to pay on this inheritance. If some of the money is in CD's, they would owe tax on the interest earned by those CD's, but not on the face value of the CD's themselves.
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Thank you Cadillac