Estate Planning: Tax Considerations

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Wednesday, Aug. 20, 2008

The Federal Estate Tax: General Principles

Your estate isn't liable for federal estate taxation unless it exceeds the available exemption amount. This is the value of assets that each person may pass on to beneficiaries without paying federal estate tax. The Economic Growth and Tax Relief Reconciliation Act of 2001 provides for a gradual increase in the exemption. It is now $1 million; in the year 2004, it will go up to $1.5 million, and then by increments to $2 million in 2006. In addition, you can pass your entire estate, without any estate taxes, to your spouse. (This is referred to as the unlimited marital deduction.) If you simply leave your estate to your spouse and don't create an appropriate trust to take advantage of your $ 1 million exemption, your spouse's estate will pay taxes on this sum when he or she dies.

To decide what the property in your estate is worth, the IRS does not look at what you paid for it, but generally uses the fair market value of property you own at your death--or, if there is a tax that is payable by reason of your death and the total value six months from date of death is lower, your executor may elect to use that alternate valuation. In many cases--especially if you've owned your home for many years--the appreciation in value of large assets could put you over the limit. For appraisal purposes, the government uses the face value of insurance policies in your name, including most group policies from work or professional organizations, but only cash value on someone else's life if you die before it has matured.

To the extent your estate exceeds the available exemption, the federal estate tax rates start at 37 percent. The assets subject to tax at death may include the family home, the family farm, life insurance, household furnishings, benefits under employee benefit plans, and other items that produce no lifetime income. In short, you may be richer than you think. If your estate is likely to exceed the threshold, however, good estate planning can sharply reduce the amount of money that goes to the government instead of to your beneficiaries.

Although the federal estate tax misses most people, it hits the rest hard: it is at least at 37% and may be as high as 50%. So if you are in jeopardy of exceeding the threshold, be sure to perform an asset inventory as suggested in the appendix, and then see your lawyer if you need tax planning.

Tax laws frequently change. Unfortunately, most people do not review their estate plans regularly. In light of the 2001 Act, you must check your estate planning documents to ensure that they still effectively shelter your estate tax exemption. If your will or living trust specifies a dollar amount, it will have to be revised. Have other specific aspects of your plan reviewed to assure that it is still effective.

Sidebar: Jointly Owned Property and The Federal Estate Tax
In valuing jointly owned property, the IRS generally divides all joint tenancy property held by spouses equally between them, no matter who paid for it; so your estate will be credited with half the value of the family home, even if your wife paid for the whole thing. (In the nine community property states, married couples hold most property jointly by law.)

If you are well-off, holding all of your property in joint tenancy with your spouse may waste one of the two $1 million federal estate tax exemptions each couple currently holds. (See above.)

Furthermore, in most cases, property you own in joint tenancy with right of survivorship with someone other than your spouse may be taxed on the basis of its total value, not just your share of it. For example, if you co-own a $90,000 house with your sister, all $90,000 may be considered part of your estate when you die, unless your executor can demonstrate that your sister paid a portion of the purchase price and any improvements. For this reason, many lawyers urge clients to avoid owning too much property in joint tenancy.

If you co-own property as a tenant in common, in contrast, your estate is only liable for tax on the percentage of ownership you had in the property: If you owned 25% of a $100,000 house, the government would add $25,000 to the value of your estate.

There is a way to convert jointly held property into two trusts that can combine many of the benefits of joint tenancy with the tax advantages of a trust. Joint tenancy undisclosed trustee titleholding, as it is known, is too complex to go into here, but you might ask your lawyer about it, especially if you have a large estate.

State Taxes on Estates and Inheritances

The federal estate tax rules apply to everyone in America. Some states also impose various taxes that effect estates or inheritances. Some states charge an additional estate tax similar to the national one, and some impose an inheritance tax. (Inheritance taxes are charged to beneficiaries, estate taxes to a person's estate.) Some states impose a separate gift tax, on top of the federal gift tax. (Gift taxes are imposed upon gifts made above a certain amount; see below.) What's taxed and at what rate depends on the law of the state you live in for intangible personal property, whenever located, and of the state in which it is located for real estate and tangible personal property. Some states have only a "pick-up" tax, which is equal to the maximum credit the Internal Revenue Code allows to the taxpayer for state inheritance taxes.

Unless your state has an inheritance tax, your beneficiaries don't pay tax when they receive money from your estate. But they will have to pay income tax on any earnings after they invest the bequest.

Capital Gains Taxes

Death itself produces a large amount of extraordinary expenditures for taxes, expenses of administering the estate, and frequently the forced early payment of outstanding debts. To obtain the cash for such payments, sales of assets are frequently made, and if the sale is for more than the date-of-death value, it may trigger a capital gains tax at the time of sale. The asset selected for sale is critical, as the tax may be deferred or accelerated depending on present or future anticipated tax brackets.

Employee Benefits

Payments under company-deferred compensation and pension plans produce a bewildering array of possible choices (lump sum, installments, etc.), with differing income and estate tax results. The federal estate tax may not apply to some employer-provided annuities or death benefits paid to your beneficiaries. Social Security payments to your dependents are not subject to federal estate tax.

Proceeds from pensions and benefit plans generally pass directly to whomever is named as a beneficiary in those plans. If, however, the proceeds are payable to the deceased's estate, they are part of the gross estate for estate tax purposes. You need to ask your lawyer or accountant about the possible tax consequences of your particular plan.

Taxes on Insurance Benefits

Many states impose an inheritance or estate tax on insurance proceeds payable to the estate, and may also do so if insurance proceeds are payable to a named beneficiary, including the trustee of either a living trust or a trust created by a will, as long as the decedent owned this policy or held incidents of ownership (see below). (The proceeds of an insurance policy paid to a named beneficiary are exempt from all federal income taxes, and almost all state income taxes except to the extent that they include interest.)

You can save on estate taxes by transferring ownership of your life insurance policy to a trust that meets certain requirements. This means the value of the proceeds won't be included in your estate. However, you must follow strict requirements:

The life insurance trust must be irrevocable.
You cannot retain any kind of ownership (incidents of ownership), such as-making decisions about the policy, or name yourself trustee.
You must transfer the ownership at least three years before you die; otherwise, the proceeds will be taxed as part of your estate. The three-year rule doesn't apply if you were never the owner of the policy; for example, you could originally take out the policy in the name of the trust or of your spouse.