Estate and gift tax planning

06 Dec, 2015 TAX LAW 0

Chapter 44
Estate and gift tax planning

Getting Started

A periodic review of your personal financial plan makes sense. Filing an annual income tax return forces most taxpayers to look over their financial situation. Yet many—perhaps most—individuals allow years to go by without adequately considering changes in property titling, beneficiary designations, or key provisions in wills and trusts. To be on the safe side, you should periodically examine the following five basic tax and financial considerations:

Have there been any tax law changes, rulings, or other developments that might either adversely affect your present estate plan or offer an opportunity to pass more of your estate at a lower tax cost?
Does your estate have sufficient cash or other liquid assets to take care of debts, taxes, funeral expenses, and estate administration expenses?
Have there been any changes in your family’s circumstances—births, adoptions, deaths, marriages, illness or disability, special schooling needs, and so on—that might call for revisions in your estate plan?
Is the current form of ownership of your assets and the current designations of beneficiaries still appropriate, meaning that the assets will pass to the right people in the right fashion? Are they appropriate for saving taxes (both income and estate) and expenses?
Should you initiate a plan to give some of your assets to your children, other family members, or charitable institutions? If you have already been making gifts, should you continue to do so? Which assets are now most appropriate for such a gift program?

Do You Need a Will?

A will is a legal document that specifies who receives what at your death and who will manage your estate. Even if you die without a will, you already have an estate plan of sorts. Generally, assets you own jointly with another person, such as a bank account, stock, personal residence, or business interest will pass to the surviving joint tenant. Where you have designated a particular beneficiary, as under an insurance policy or IRA, the asset will pass to the designated beneficiary. But assets you own in your name alone will be passed on in accordance with your state’s laws if you die without a will.

If you die without a will—intestate is the legal term—state law determines how your estate is divided up among your surviving spouse, children, and parents—and what happens when there is no surviving spouse. However, state law may not conform to your wishes. Often, the biggest problem is not who will receive the property, but how and when they get it. Another important issue is the guardianship of minor children. If both parents die without a will that directs who will be guardian of a minor child, the court and the state social welfare department will make the decision. So, even if you do not have enough assets to pay federal estate tax, it’s a good idea to draw up a will and a trust.

TAXPLANNER

The significant estate tax exemption discussed above—exempting estates worth under $5.34 million for 2014 from tax and indexing that exemption for inflation—certainly makes estate tax planning easier for many Americans. But that should not lull you into thinking that planning is unnecessary. For starters, you may be worth more than you think. Despite the nationwide downturn in housing values with the bust of the housing bubble in 2007, many middle-class families still own homes that are worth much more than what they cost, and housing values have been rising in many areas. Moreover, even in this era of economic turmoil and heightened volatility in stock and bond prices, many investors still hold significant investment portfolios. And, in many cases, the proceeds of life insurance are also included in your taxable estate regardless of the beneficiary.

Even if your assets do not currently create a taxable estate, they might at the time of your death. Therefore, it is prudent to focus on strategies that help freeze the value of assets in your estate.

Table 44-1. Estate, Gift, and Generation-Skipping Transfer (GST) Tax Rates and Unified Credit

Exemption Amount Calendar Year	Estate, Gift, and GST Tax Exemption	Highest Estate, Gift, and GST Tax Rates
2014	$5.34 million for estate, gift, and GST tax	Estate, gift, and GST tax at 40%

TAXSAVER

You can transfer ownership of a life insurance policy to your children or to a trust for your family’s benefit and reap significant estate tax advantages. To be effective in keeping the proceeds out of your estate, the gift must be made more than three years before death. The three-year waiting period can be avoided for a newly purchased policy if proper steps are taken to have someone else (e.g., a trustee of an irrevocable life insurance trust) apply for the policy and own it from its inception. These types of irrevocable life insurance trusts can be structured so that your contributions each year to the trust can qualify for the annual gift tax exclusion (explained below). Setting up such a trust can be an effective way to remove the insurance proceeds from your estate, thereby reducing your estate tax.

Employee benefits. The value of payments from qualified pension plans, IRAs, and other qualified or nonqualified retirement plans payable to surviving beneficiaries or the estate of an employee (or the owner, in the case of a Keogh/HR 10 plan) generally is included in your gross estate.

Certain gifts and gift tax paid within three years of death. Gifts of property made during your lifetime are generally not included in your gross estate, but must be figured in the estate tax calculation if they exceed the $14,000 annual gift tax exclusion (discussed later). However, life insurance proceeds are included in your estate if the policies or ownership of the policies were given away within three years of your death. Also included is any gift tax you have paid within three years of your death. Lifetime gifts in which you retain some interest (e.g., a life income interest) or control (e.g., voting rights in closely held stock given as a gift) will be included in your gross estate.

Allowable deductions and exclusions. Deductions are allowed for funeral and estate administration expenses, and debts—such as unpaid mortgages—and other indebtedness on property included in the gross estate. Also allowed are special deductions such as the marital deduction and the charitable deduction. (See later sections for more details on the marital deduction.)

Funeral and administration expenses. Deductible funeral expenses include burial costs, costs for a burial lot, costs for future care of a grave site, and so on. Deductible administration costs include executor’s commissions, attorney’s fees, accounting fees, appraisal fees, and court costs.

Other deductible estate expenses. To be deductible, debts must be enforceable personal obligations of the decedent, such as mortgages or personal bank loans, auto loans, credit card balances, utility bills, and so on. The deductible amount also includes any interest accrued on such debt at the date of death. Transfers made under a marital property settlement because of a divorce may be treated as estate expenses. Taxes are also deductible debts if they are accrued and unpaid at date of death. Deductible taxes include accrued property taxes, gift taxes unpaid at death, and income taxes.

Valuing estate property. Property is included in an estate at its “fair market value,” which is the price at which property would change hands between a willing buyer and a willing seller. Property that trades on an established market may be valued easily. For example, publicly traded stocks and bonds are valued based on the average of the high and low selling price on the date of death (or, if elected, the date six months after death). However, interests in closely held businesses or partnerships must generally be appraised, taking into account the business’s assets, earning capacity, and other factors. An accountant can assist you in obtaining the appropriate appraisal of your business interests for estate or gift tax valuation purposes.

Your gross estate is valued as of the date of your death or six months later (also known as the alternative valuation date), whichever your personal representative elects. An election to value the estate six months after the date of death will generally apply to all assets in the estate, but is available only if the election results in a decrease in your gross estate and estate tax liability.

The amount remaining after subtracting any allowable deductions is your taxable estate. The federal estate tax is computed on this amount. Gifts made after 1976 are also factored in and can increase the marginal tax bracket of the estate.

If You Are the Beneficiary of an Estate

Property acquired from a decedent generally gets a new basis. Basis is generally the cost of an asset or the amount you will use to figure your tax when you sell the asset. In most cases, the new basis is the fair market value at date of death or alternative valuation date, whichever is used for estate tax purposes. If the new basis is greater than the old basis, this is known as your “stepped-up” basis.

How Your Estate Is Taxed

Tax rates. The federal estate tax is progressive, ranging from a marginal rate of 18% to 40% in 2014. The 40% top rate will apply to estates larger than $5.34 million.

Credits and Exemptions

Your estate can claim certain credits and exemptions before figuring the amount of federal estate tax owed. These items include:

Estate tax exemption. Each individual is entitled to an estate tax exemption. For 2014, the exemption is $5.34 million. In other words, no federal estate tax will be assessed on the first $5.34 million of an individual’s combined taxable gifts and transfers at death. To the extent that the exemption has been used to offset gifts the decedent made during his or her lifetime, the exemption against the estate tax is reduced. While you should have your estate plan reviewed on a regular basis, it is especially important to be sure it is drafted to take advantage of the estate tax exemption available under the law in existence at the time of your death.

Example. Mary had an estate valued at $5.34 million at the time of her death in 2014. Two years before she died, she gave her son Bill a gift of $340,000 to help him buy a house. Instead of an estate tax exemption of $5.34 million, only $5 million of Mary’s estate will qualify for the exemption.

The marital deduction. One of the most significant tax-saving provisions of the law is the marital deduction. As its name implies, it is a special deduction available only to married persons, where the spouse receiving the assets is a U.S. citizen. An estate is allowed an unlimited deduction for the value of property transferred to the spouse of the deceased. Thus, in effect, the marital deduction permits a couple to postpone paying any estate tax until the surviving spouse dies.

TAXSAVER

Most married individuals who have or will have taxable estates will want to take advantage of both the estate tax exemption and the unlimited marital deduction. The marital deduction is only available for U.S. citizen spouses and will reduce the federal estate tax to zero for the estate of the first spouse to die. The coordinated use of the exemption and the marital deduction is usually accomplished by transferring property in a special type of trust, often called a bypass trust. These trusts, which are used to take full advantage of a spouse’s estate tax exemption, typically provide income and discretionary distributions of principal to the deceased’s surviving spouse. The amount that goes into these trusts is typically determined by a formula that puts the maximum possible amount into the trust without generating federal estate tax in the deceased spouse’s estate. Assets in excess of the remaining exemption either pass to the surviving spouse outright or remain in a form of trust that will qualify for the estate tax marital deduction. The advantage of the bypass trust is that its assets will not be included in the surviving spouse’s estate at his or her death, regardless of the amount in that trust at that time.

Portability. If a spouse passes away during 2014, the surviving spouse can add to his or her own exemption whatever amount of the exemption—up to $5.34 million if death occurred during 2014—the deceased had not used during his or her lifetime. In order to take advantage of this option, an election must be made with a timely filed estate tax return for the deceased spouse, even though the estate of the deceased spouse many not be large enough to require the filing of an estate tax return.

A surviving spouse will be able to use the deceased spouse’s unused exemption for lifetime transfers as well as his own at death. However, portability does not extend to the generation-skipping transfer (GST) tax exemption.

Prior to the availability of portability, a typical plan for an estate in excess of the estate tax exemption equivalent would be to fund a bypass trust with the decedent’s remaining unused amount of estate tax exemption equivalent. By funding the bypass trust at the death of the first spouse, the full, remaining amount of the estate tax exemption plus future appreciation would not be included and taxed in the estate of the surviving spouse. If an estate plan did not fund a bypass trust, all assets transferred to the surviving spouse under the marital deduction upon the decedent’s death would be includable in the surviving spouse’s estate. Therefore, the full value of the exemption of the deceased could go unused and possibly be lost. Even though no estate tax would be due upon the death of the first spouse, a larger estate tax would be due upon the death of the surviving spouse.

Under the portability rules, there would still be no tax due on the first-to-die. However the deceased’s exemption would not be “wasted.” Instead, any of the deceased’s unused exemption carries over to the surviving spouse. While the portability rules provide relief in the ability to use a deceased’s unused exemption, the funding of a bypass trust should continue to be considered in an estate plan. First, the funding of a bypass trust at the death of the first spouse removes the exemption equivalent amount and the associated future appreciation from the surviving spouse’s estate. Second, the traditional benefits of using a trust, such as creditor protection, should be considered as well as the possibility of the surviving spouse remarrying and the potential inability to use the first deceased spouse’s unused exemption amount. Third, the bypass trust may be needed to assure that the children of a deceased spouse’s prior marriage are not disinherited by the surviving “new” spouse. Finally, portability is not allowed for GST tax exemptions, so a surviving spouse would not be able to use the unused GST tax exemption of the first-to-die.

The following examples explain how an estate or gift tax exemption can be transferred from a deceased spouse to a surviving spouse.

Example 1. Assume that Husband 1 dies in 2014, having made taxable transfers of $3 million and having no taxable estate. An election is made on Husband 1’s estate tax return to permit his Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, the Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7.68 million (her $5.34 million basic exclusion amount plus $2.34 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.

Example 2.

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