OVERVIEW
The federal gift and estate tax system is a unified system that taxes all transfers made by an individual, including lifetime gifts and bequests made at death.
- Basic Tax Concepts:There are a number of primary tax concepts that affect the amount of taxes your estate may owe.
- Calculating Federal Estate Tax: Because the federal estate and gift tax system is complex, it is helpful to see how it is calculated.
- State Death Tax: Each state has its own laws for taxing the transfer of estate property.
Basic Tax Concepts
The federal gift and estate tax system is a unified system that taxes all transfers made by an individual, that is, both lifetime gifts and bequests made at death. The gift tax is a tax on the right to transfer property during your lifetime and the estate tax is a tax on the right to transfer property at your death.
There are several key concepts that must be understood to effectively minimize the impact of estate taxes:
- Transfers to Spouses (Unlimited Marital Deduction Rule): There is no federal gift or estate tax liability on transfers between spouses. The amount that can be transferred tax-free to a spouse is unlimited.
- Annual Exclusion Rule: Under current law, you can make gifts of up to $10,000 per year to any donee (whether or not the donee is your spouse) with no liability for federal gift or estate taxes. A husband and wife may transfer $20,000 to a single donee without the imposition of gift taxes. These amounts of $10,000 and $20,000 are now "indexed" and can be expected to increase in future years because of inflation.
- Federal Exclusion: After excluding gifts that qualify for the annual exclusion, you can transfer an additional $2,000,000 (the 2007 amount), and possibly as much as $3,500,000 (the 2009 amount), to non-spouses with no liability for federal estate or gift taxes.
This federal estate tax applicable exclusion amount is really a unified credit. The federal estate tax applicable exclusion amount is usually used to protect transfers that are made from your estate at your death. However, you can use up some or all of your exclusion amount by making large gifts during your lifetime.
- Other Taxes: In addition to federal estate and gift taxes, assets that you transfer may be subject to other taxes.
Calculating Federal Estate Taxes
Federal estate tax is imposed on the gross estate (all the assets you own at your death), minus the allowable deductions, plus any taxable lifetime gifts.
Determining Your Taxable Estate
The value of the property included in your estate for tax purposes is the fair market value of each asset at the time of death. Additionally, the types of assets you own will affect their value. If the amount of your gross estate is less than the federal exclusion amount available at your death (or less if you used part of your exclusion to make lifetime gifts), no federal estate taxes will be owed.
The federal tax rates on estates of more than the 2007 federal estate tax applicable exclusion amount of $2,000,000 depend on the value of the estate. For 2007, the top rate is 45%. In 2010, the estate tax will be eliminated completely. However, In accordance with federal tax legislation passed in June of 2001, the federal estate tax will be repealed at the end of 2010. Unless the 2001 tax law is extended, as of January 1, 2011, the top rate will return to 55%.
Reducing Tax
- Deductions that may be subtracted from the gross estate to determine the amount of the taxable estate include: the marital deduction, funeral expenses, administrative costs, debts of the estate, mortgages and liens, and charitable contributions.
- Adjustment for Lifetime Gifts If you made gifts in excess of the annual exclusion during your lifetime, these excess amounts will be added to your taxable estate at this point. This may seem unfair, but you will be allowed to deduct the full amount of the unified credit, even though you used some of the unified credit to avoid paying the gift taxes that would have been owed on your lifetime gifts.
- Credits Against the Estate Tax There are several credits that can be used to reduce the amount of taxes that would otherwise be owed.
Filing the Return and Paying the Tax
The federal estate tax return must be prepared and filed if the estate has gross assets of $2,000,000 or more, even though no tax may be owed.
State Death Taxes
Each state has a separate system of taxing property transfers that occur at death. Generally, state death taxes are handled by one of the following methods:
- State Estate Taxes
Similar to the federal estate taxing scheme, state estate taxing schemes tax the right to transfer property. Thus, the tax is imposed on the value of the estate as a whole, and the tax must be paid by the estate. The deductions, exemptions, and credits are similar to the federal system.
- State Inheritance Taxes
An inheritance taxing scheme taxes the right to receive property, not transfer it. The tax is imposed on the value of the property transferred to each beneficiary (not the value of the estate as a whole), and the tax liability is the responsibility of the person receiving the property (not the estate). The amount of the tax to be paid by each beneficiary depends on how much the beneficiary receives and the relationship of the beneficiary to you. Usually, the more closely related the beneficiary is to you, the lower the rate of tax. That is, spouses and children would be assessed a lower rate of inheritance taxes than someone who is more distantly related or not related at all.
- State “Pick-Up” Estate Taxes
Many states have a “pick-up” estate tax that is designed to take advantage of the “state death tax credit” that is allowed against the federal estate tax. These states charge a state death tax that is exactly equal to the amount of the federal “state death tax credit” that is allowed as a deduction on the federal return.
- Combined State Systems
Some states combine their tax systems to collect the optimal amount of tax. For example, a state may have both an inheritance tax system and a pick-up tax.
SPOUSAL PLANNING
Trusts are often used to minimize taxes for surviving spouses and achieve non-tax objectives as well. These trusts are created at your death in accordance with trust terms provided in either your will or your living trust.
There are several trusts commonly used to minimize taxes for surviving spouses:
- Credit Trust: Spouses frequently leave all or most of their property to their surviving spouse when they die. The credit trust, a type of bypass trust, maximizes the use of the federal estate tax applicable exclusion amount for both spouses by placing assets in a trust.
- Disclaimer Trust: Another type of bypass trust, the disclaimer trust is a less conservative option than a credit trust, but gives the surviving spouse more control over assets.
- QTIP Trust (Qualified Terminal Interest Property): A QTIP trust can be used to obtain the tax benefit of transferring property to a surviving spouse while retaining the right to determine the ultimate distribution of the property. This allows you to obtain the marital deduction and still retain control.
Credit Trusts
A credit trust is a form of bypass trust because the assets in the trust “bypass” the estate of the spouse who dies second. This type of trust has a variety of other names, including credit shelter trust, family trust, and B trust. Because both spouses have a federal exclusion that allows each of them to protect $1,000,000 (the year 2007 amount) or more in assets, $2,000,000 in assets can be protected from federal estate tax with proper planning. The problem is, without proper planning all or part of the federal exclusion the spouse who dies first will be wasted.
The use of a credit trust can save a substantial amount in federal estate taxes. While a credit trust can save substantial amounts in estate taxes, there are restrictions involved. An example of how to use a credit trust is available by clicking on this text.
Disclaimer Trust
A disclaimer is your refusal to accept property from an estate or trust that would otherwise be distributed to you. It may seem odd to refuse property, but you may want to disclaim property if it saves taxes and if you are satisfied with who receives the property instead of you.
If you disclaim the property, generally it will pass to your heirs as if you had died without a will. Your heirs will be your children and descendants, if you have any, and if you have no children, your heirs will be other relatives. In this situation, the person who disclaims is in control by re-directing the property to the disclaiming person's heirs.
Disclaimed property can also be controlled by the person who originally owned it (instead of by the persons who would have received it). You can provide in your will (or living trust) what will happen to property if any of your beneficiaries use this disclaimer technique. This allows you (not the person who would have received the property) to control where the property goes.
Specifically, you can provide that if your spouse disclaims any property, the disclaimed property will pass into a disclaimer trust. The disclaimer trust can then have the same type of provisions as the credit trust. That is, distributions can be made from the trust for the support of the spouse, and at the spouse’s death, final distributions can be made to your other beneficiaries.
There are important differences between credit trusts and disclaimer trusts. The credit trust approach is conservative and ensures that the federal exclusion of the spouse who dies first is used to the greatest extent possible. The disclaimer trust approach places the decision of how much to put into the trust in the hands of the surviving spouse. However, it also leaves open the possibility that the surviving spouse will make a decision that may waste some of the exclusion amount.
QTIP Trust (Qualified Terminal Interest Property)
In some situations, a spouse wishes to obtain the tax benefit of transferring property to a surviving spouse while retaining the right to determine the ultimate distribution of the property. For example, Joe would like Mary to have access to his assets after his death, and for his estate to benefit from the marital deduction his estate would receive if he gave his assets outright to Mary. However, Joe does not want to take the chance that after his death Mary might give the property to beneficiaries that Joe does not like, perhaps her relatives or a new husband. A QTIP trust can be used to obtain the marital deduction, while retaining the right to control who will eventually receive the property when the surviving spouse dies.
If the QTIP trust requirements are met, property can be transferred into a trust for the benefit of the surviving spouse. Because of the unlimited marital deduction that will be allowed for this special kind of trust, the property will not be taxed in the estate of the spouse who dies first. The surviving spouse will have to include the QTIP property in his/her estate, the same result that would occur if the property would be given outright to the surviving spouse. However, the QTIP trust provisions (not the surviving spouse) will dictate the distribution of the QTIP assets at the death of the surviving spouse. See Using a QTIP Trust.
GIFTING
Gifting is another method commonly used to minimize your estate taxes.
- Family Gifting: This technique uses the annual exclusion rule. You can make gifts of up to $10,000 per year to any donee with no liability for federal gift or estate taxes.
- Charitable Gifting: While the annual exclusion rule allows for tax-free transfers up to $10,000 to individuals, charitable gifting rules allow for tax-free transfers of any amount to qualified charitable organizations.
Family Gifting
Use of the annual exclusion allows you to make gifts of up to $10,000 per year to any donee (whether or not the donee is your spouse) with no liability for federal gift or estate taxes. Further, these gifts do not use any of your federal estate tax applicable exclusion amount. There are several ways to use the annual exclusion rule including cash gifts, gifts of other property, and gifts to trusts.
The annual exclusion is generally used by couples and individuals who are comfortable with the amount of their wealth and are willing to give up the use and enjoyment of some of it during their lifetimes. It is also used by married couples with assets in excess of their combined federal exclusion amount or single individuals with assets in excess of the federal exclusion amount who want to minimize the impact of federal estate taxes on their excess assets. In addition, the annual exclusion is sometimes used by married couples who want to avoid federal estate taxes, but they do not want to bother with using a credit trust that would help them shelter up to two times the federal exclusion amount from federal estate taxes. These couples monitor their wealth closely and make annual gifts that keep their combined wealth from increasing above the federal estate tax applicable exclusion amount.
Charitable Gifting
Gifts of unlimited amounts may be made to qualified charitable organizations. These gifts may be made during your lifetime or at your death. Either way, the transfer reduces the amount of your estate that would otherwise be subject to federal estate taxes. These gifts may be made during your life or at your death. However, lifetime charitable gifts have an income tax advantage over charitable bequests that are made at your death. In addition to the estate tax benefits that both types of gifts enjoy, lifetime charitable gifts can have income tax benefits, including an income tax deduction and capital gains avoidance.
A gift of a life insurance policy can be an effective method of charitable gifting with significant estate planning results.
For some people, making a lifetime charitable gift is more attractive if they can give an asset to charity, but retain the future income from the gifted asset. This type of arrangement can be made if you are willing to give up some of the charitable income tax deduction that is generally available for lifetime gifts to charities.
OTHER TECHNIQUES
There are additional ways estate planning can minimize federal estate taxes.
- Life Insurance Trusts: This type of trust reduces taxes because the trust, not your estate, owns the life insurance proceeds.
- Retirement Plans: Income tax on retirement plans is not due until the funds are withdrawn.
Trusts and certain types of beneficiary designations can minimize the amount of tax you will need to pay.
Life Insurance Trusts
An irrevocable life insurance trust is another technique used to minimize federal estate taxes. A life insurance trust is a trust created by an individual (and sometimes the spouse) to own life insurance on the life of the individual and/or the individual’s spouse. The advantage of using the life insurance trust, rather than simply owning the life insurance outright, is that the life insurance proceeds received by the life insurance trust at the death of the individual are not included in the individual’s estate.
Retirement Plans
Many individuals have retirement plans in which they have accumulated significant investment funds that have a very important tax characteristic -- these funds represent income on which income taxes have not been paid. In most cases, these funds cannot be withdrawn without penalty until you reach age 59 1/2 years. When you do withdraw the funds, you will have to pay income taxes on the amount withdrawn. Most income tax planners follow certain general rules in order to obtain the best tax benefits.
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