In general, most estate distributions are not subject to income tax. In some cases, however, a distribution from an estate may include income that can be taxed, but this is a rare occurrence.
The U.S. government does not have any form of inheritance tax. Thus, an estate distribution than an heir receives as a beneficiary is inherited tax-free. A limited number of states require payment of inheritance tax. Also, in instances where the estate has failed to pay income tax prior to distribution, the U.S. government may attach limited beneficiary taxes to distributions. As is true for an individual, an estate must use an income tax return to report an income. Though estates can generate income in several ways, the most common income is earned in the form of interest on the accounts that it owns.
Though an estate must report this income, it may also distribute the taxable income to heirs. The estate may distribute this income along with the inheritance. For example, if an estate makes a distribution of $10,000 to an heir, it is likely that $2,000 to $3,000 of the distribution is taxable income, while the remaining $7,000 to $8,000 is the actual inheritance.
In the end, this saves the heir money. An estate is subject to the top tier of tax rates significantly quicker than an individual. The heir who must put $2,000 or $3,000 on a personal tax return ultimately receives more of than money, as less tax is deducted from it than if it were taxed as part of the estate's income. The heir then receives a Schedule K-1 form from the IRS and has to report the taxable income on his own income tax return.