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 2010 Legislation. On December 17, 2010, as part of the extension of the Bush Tax Cuts, the Congress passed and the President signed into law a number of changes to the federal estate tax laws. Please read our post Federal Estate Tax Awakens From Lengthy Coma for more detailed information on this important legislation. As a result of this legislation, the per-person exemption from the federal estate tax has risen to $5.0 million in 2011 and 2012. 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 35% federal estate tax on the excess, which is due within 9 months of the decedent’s death. If Congress and the President do not change the law, the per-person exemption will be reduced to $1.0 million for decedents who die in 2013 and subsequent years.
The By-Pass Trust Concept. If the new law is made permanent, it would enable married couples to pass as much as $10 million to their children or other loved ones free of any estate tax or gift tax. However, given the possibility the exemption will be reduced in 2013, we still counsel many of our married clients with modest wealth to make use of a by-pass trust in their estate planning. This will ensure that the couple does not “waste” one of their two exemptions upon the death of the first spouse to die.
Creating and Funding a By-Pass Trust. 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 unified credit. Usually, the surviving spouse is the beneficiary of the by-pass trust and the trustee. Typically it provides that trust assets can be used for the support, maintenance, and health of the surviving spouse, terms which are interpreted very 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 fund the by-pass trust at death if he has not (i) properly titled his investment assets or (ii) named the correct beneficiary designations on his life insurance policies and retirement plan accounts. An important part of the service we provide is to instruct a client on asset titling and beneficiary designation issues.
Portability. The new legislation also provides for the portability of the estate tax exemption of the first spouse to die. Portability 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. Portability is a revolutionary concept and was introduced into the law for the first time ever in the 2010 legislation. It will certainly become more important in estate tax planning if the new laws are extended beyond 2011 and 2012.
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) annual gifts to children and grandchildren, (ii) funding irrevocable trusts through life insurance, (iii) transferring primary or vacation residences into qualified personal residence trusts (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.