With an incoming presidential administration and a Democrat majority in Congress that promises to raise taxes on the wealthy, there is a good chance that the federal estate tax could increase and you could owe more taxes when you die. The federal estate tax is a tax on your right to transfer property at your death. The new administration could try to reduce the federal estate tax exemption and even raise the tax rate. Therefore, an effective estate plan with estate tax considerations is more important than ever. Luckily, there are some ways to reduce, limit, or completely avoid estate taxes, depending on the size of your estate when you pass away.
Neither lifetime gifts nor bequests in a will are subject to estate taxes if these assets are transferred to a surviving spouse. The exception is if a spouse is a non-citizen. The marital transfer estate tax exemption does not really eliminate estate taxes. It simply defers the tax bill. When the second spouse dies, estate taxes will be owed on the entire taxable estate, including the assets transferred upon the first spouse’s death.
Lifetime Gifts to Children and Grandchildren
Each member of a married couple can make annual, tax-free gifts to any number of people each year. This is limited up to a federally determined gift exclusion limit without incurring a gift tax.
In 2022, that limit was $16,000. If both spouses engage in gifting, they could collectively give away their combined exemption amount $32,000 a year without incurring a gift tax. Over a period of years, the amount of money that can be transferred to a couple’s intended beneficiaries in this way could be substantial. It can reduce the value of the taxable estate, which reduces federal and state estate taxes.
Gifting to Minors
There are two gifting methods that allow a gift to minors without gift tax consequences:
This applies until they come of age (aged 18 or 21, depending on the state where they live).
The Uniform Gifts to Minors Act (UGMA): allows gifts of cash and securities to be transferred to underage children. The Uniform Transfers to Minors Act (UTMA): allows a minor child to be the beneficiary of a gift of money or real property. That could include real estate, royalties, patents, valuable artwork, and antiques, as well as cash and securities.
Assets held in these types of accounts may be managed by the grantor (donor), or by a custodian named by the grantor. The IRS allows an exclusion from gift tax up to the annual exclusion limit ($16,000 in 2022). The receiver will be taxed for any gift over that amount, but at the tax rate of the minor. Earnings from these accounts are also taxed. One potential drawback to this type of gifting is the impact it can have on student financial aid qualifications.
Marital Trusts (AB Trusts and QTIP Trusts)
In 2022, the personal estate tax exemption — the value of assets that can be transferred to an heir before estate tax is due is $12.06 million. There are two types of marital trust that allow each spouse to use that personal exemption to the fullest extent possible without disadvantaging the surviving spouse. These are AB trusts and QTIP trusts. Each spouse can transfer their separate assets and share of community property assets into a trust for the benefit of their surviving spouse. The grantor spouse retains control over the ultimate disposition of those assets at the time of the second spouse’s death. The surviving spouse has use of the assets of the decedent spouse’s property for the remainder of the surviving spouse’s lifetime. They can use the personal property in the trust as defined in the trust document.
Here’s where the difference comes in:
As such, a QTIP trust tends to be popular in situations where the donor spouse is married for a second time but has children from a first marriage who will inherit their parent’s assets. An AB trust may be more common in situations where there are only children from the marriage.
Irrevocable Life Insurance Trust (ILIT)
A life insurance trust is a financial planning tool with a variety of tax benefits. Funds transferred into the life insurance trust are used to pay premiums for one or more life insurance policies. These could be:
Because it is an irrevocable trust, money placed in the trust is tax-deductible in that tax year. When the donor dies, the trust inherits the life insurance proceeds, not the estate. Assets distributed through the trust are not subject to estate taxes. So, among its many benefits, an ILIT can reduce state and federal taxes owed on one’s yearly tax return during life, and can avoid estate taxes after death, while allowing the donor to control the timing and distribution of an inheritance in the trust.
Family Limited Partnership
A family limited partnership is an estate planning tool available for families with business interests. It is a family-owned holding company, which can be set up as a limited partnership (LP) or a limited liability company (LLC). It minimizes income tax, ensures continuity of ownership of a business and other assets, and it limits liability for family partners. There are two classes of owners in the family limited partnership:
The general partners put assets into the partnership and then gift an interest or share in the partnership to family members. Because that share can’t be sold to anyone other than a family member, it lacks marketability. Under tax law, the value of such an interest can be discounted from 15% to 30% in value. That discount alone can mean the difference between paying federal estate tax or not. Suppose that a limited partner has a lot of debt. Can they raid the family partnership to pay their bills? No, the limited partner has no control or access to assets in the partnership unless the general partners give them access. Assets in the partnership are protected until they are distributed. Partners are responsible for paying income tax on their share of income from the business of the family limited partnership. Growth in the value of assets in the family limited partnership is also free of inheritance tax and estate tax.
When the general partners typically the parents or grandparents are ready to transfer control, they can decide who will receive their interest. It could be a family member, or it could be a trustee.
A private annuity results from the sale of an asset to (usually) a younger family member. It is sold in exchange for a promise to pay annual amounts to the seller (also called an annuitant) for the seller’s lifetime. The asset is no longer part of the seller’s estate so the value of their estate is reduced. Annuity payments received from the buyer do become part of the seller’s estate.
Special Use Real Estate Valuation
For federal estate tax purposes, real estate is usually valued at its “highest and best use” value. This can sometimes produce unfair results, such as where a family farm is adjacent to more valuable commercial real estate. To address this unfairness, the Internal Revenue Code permits certain real estate to be valued for its “actual use” rather than its “highest and best use.”
Qualified Personal Residence Trust (QPRT)
We’ve seen earlier that a variety of trusts can be used to transfer a home after the death of a spouse while allowing the second spouse to remain in the home until their death. A qualified personal residence trust allows both homeowners to put their home into trust for their children while allowing them to continue to live in the home for a set number of years. If the home increases in value during the parents’ lifetime, the amount of the increase will not be added to the home’s value when the home is gifted to the children. If you live in a state with quickly appreciating property values, this can be a boon. It reduces the amount of gift tax on the estate. A QPRT can be a risky choice. If the grantor-homeowners die before the end of the trust, there will be no tax savings for the trust beneficiaries.
Charitable Trusts and Charitable Transfers
Lifetime charitable transfers or gifts to charities upon death can reduce the value of your estate and thereby reduce estate taxes. Lifetime gifts provide the added benefit of an income tax deduction. Gifts can also be made in a manner that lets the donor retain the right to use the gifted asset or income therefrom until death.
Estate Tax Exemptions
Under IRS statutes, there are three main exemptions to the estate tax. To begin with, each estate is allowed a $2 million exemption on virtually all assets and property. This means that any estate with a value lower than $2 million pays no taxes, while an estate worth, say, $5 million, would only be subject to taxes on $3 million. This makes a huge difference in the total amount of taxes your estate is forced to pay. In addition, under the current laws, this standard exemption is scheduled to increase from $2 million today to $3.5 million in 2009. The bad news? The law is expected to change in 2010, reducing the exemption to a paltry (by comparison) $1 million.
Second, a tax exemption is granted to the estate in the amount of any property, assets, or cash passing from the deceased to his or her spouse. Therefore, if a husband dies and leaves his entire estate to his wife, no estate tax will be due. Furthermore, a similar exemption is granted for any donations made to a qualified charity organization. In other words, leave your estate to your spouse or a charity, and estate taxes are avoided.
One important fact to note is that the standard $2 million exemption and the spouse and charity exemptions are not mutually exclusive; that is, an estate can take advantage of all three, if planned correctly.
Who Has to Pay Estate Tax?
Technically, it’s the estate itself that has to pay estate tax. Because of this, the question “who is subject to estate tax” is almost a trick. The executor of the estate is responsible for filing and paying any taxes that are due on behalf of the estate. As of 2021, only estates with a total value of $11.7 million or more must pay the federal estate tax. The federal estate tax is only assessed on the value that exceeds this threshold. According to the Internal Revenue Service (IRS), the fair market value of assets is used, and not the original purchase price or acquisition value. When the taxes are filed, certain deductions can be made. Example deductions include mortgages, debts, administration costs, and the value of property passed on to surviving spouses or charities. There are some states in the U.S. that also have estate taxes. If you live in one of these states, you might be facing a double-whammy.
What Assets are Excluded from Estate Tax?
So far, we’ve alluded to an estate as a general collection of assets. While this is true, it’s important to note that an estate can include a wide variety of assets and property. There are, in fact, some asset types that are excluded (exempt) from estate tax.
Assets exempt from federal estate tax:
Assets that are not exempt: