Clients of even modest wealth have these two fundamental concerns. Will my estate have to pay federal estate taxes when I die? If so, how can I lawfully reduce my exposure?
Key Elements to the Federal Estate Tax. The federal estate tax is a tax on the transfer of wealth at death. Its younger brother, the federal gift tax, is a tax on the transfer of wealth during one’s lifetime. The federal estate tax has been part of American law since 1916. The gift tax was added later, in 1931.
Since 1981, the law has allowed a specific amount of a person’s estate to pass at death free of any estate tax. This is called the unified credit. Those same laws allow an individual to leave an unlimited amount free of any estate tax to a spouse who is also a U.S. citizen. This is called the marital deduction.
Important 2013 Legislation. On January 2, 2013, the President signed legislation that made permanent many of the features of the federal estate tax laws known as the Bush Tax Cuts that would otherwise have expired. Please see our post Bush Tax Cuts Live On for more information on this legislation. As a result, the per-person exemption from the federal estate tax has risen to $5.34 million in 2014. If a decedent’s estate exceeds this amount (after taking into account various deductions such as the marital deduction), that decedent’s estate will be subject to a 40% federal estate tax on the excess.
Portability. The legislation also made portability a permanent part of the federal estate tax code. Portability is a technique available to married couples to reduce estate taxes. It allows the surviving spouse to add the unused estate tax exemption of the first spouse to die to the surviving spouse’s estate tax exemption. This is accomplished by filing a federal estate tax return on IRS Form 706 for the estate of the deceased spouse and making the elections provided on that tax return.
Portability was a revolutionary concept when it was introduced into the law for the first time ever in 2011. With proper planning, a married couple can now pass as much as $10.68 million to their children and grandchildren free of federal estate tax. Many high-net-worth married couples will rely on portability to preserve the estate tax exemption of the first spouse to die. However, we expect many married couples with wealth in excess of the per person exemption ($5.34 million in 2014) will use by-pass trust planning instead to preserve the deceased spouse’s exemption and to achieve other important estate planning goals.
The By-Pass Trust Concept. A by-pass trust can also help ensure that a married couple does not “waste” one of their two exemptions upon the death of the first spouse to die. Typically, the first spouse to die will have established a by-pass trust (also referred to as an exemption trust or a credit shelter trust) in that spouse’s estate planning documents, to be funded only upon that spouse’s death, and only up to the amount of the decedent’s remaining exemption. The surviving spouse can be the beneficiary of the by-pass trust and the trustee, but it can have other beneficiaries and other trustees. Typically it provides that trust assets can be used for the support, maintenance, and health of the surviving spouse, terms which are interpreted generously under the federal estate tax laws and regulations.
Asset Titling and Beneficiary Designations. A person can have the proper estate planning documents in place and still fail to achieve one’s estate planning intentions if the person has not (i) properly titled his investment assets or (ii) named the correct beneficiary designations on his life insurance policies, annuities, and retirement plan accounts. An important part of the service we provide is to instruct a client on asset titling and beneficiary designation issues.
Other Estate Tax Reduction Strategies. Once planning to preserve each spouse’s exemption has been performed, other tax planning options may be considered for clients who still face estate taxes at their deaths. These include (i) making annual gifts to children and grandchildren, (ii) transferring ownership of a life insurance policy to an irrevocable trust, (iii) transferring a primary or vacation residence to a qualified personal residence trust (known as QPRT’s), and (iv) creating and funding grantor retained annuity trusts (known as GRATs). We have experience drafting and implementing these and other estate planning tools.