The estate tax is still around, but it is as good as dead for the vast majority of people. When I began practicing in tax in 1996, anyone who had a gross estate over $600,000 had to be concerned about the estate tax. This $600,000 amount was the estate tax exemption amount for that year. The gross estate for U.S. citizens and permanent residents includes assets held throughout the world, the face amount of life insurance, and various other items that may surprise taxpayers.
I Would Die 4 U and File a 706 Return
While the estate tax is applied to asset transfers upon his or her death, the gift tax applies to transfers made during life. This prevents people from gifting all their assets shortly before death to avoid the estate tax.
The estate tax exemption amount for 2016 is $5.45 million, and is indexed for inflation. Anyone with a gross estate under $5.45 million will not have to file an estate tax return or pay the estate tax. While anyone with a gross estate over $5.45 million will have to file an estate tax return, there may not be a tax due because the gross assets are reduced by liabilities, estate tax deductions, and the exemption amount. These items may reduce the taxable estate to nothing. The estate tax rate is currently 40%. Besides the estate tax exemption, another significant deduction is the marital deduction. Basically, the first spouse to die could transfer his or her assets to the surviving spouse after death and receive a deduction from estate tax. The problem with this strategy is that It wasted the first deceased spouse’s exemption amount.
Example: John and Joan are married. For this example, the estate tax exemption amount is $1 million. Each of them has $1 million in assets. If all of John’s assets are transferred to Joan upon his death, he would owe no estate tax because his $1 million gross estate is reduced to $0 by the marital deduction. The problem is that Joan now has $2 million in assets. When she dies, her gross estate is $2 million. The $2 million gross estate is reduced by her $1 million estate tax exemption leaving her with a $1 million taxable estate. If the estate tax rate is 40%, her estate tax would be $400,000.
Nothing Compares to Portability
Portability refers to the new ability of one spouse to transfer her unused estate tax exemption to her surviving spouse. Before portability, each spouse had an exemption amount and the exemption amount could not be transferred to the surviving spouse. A common tax planning technique was to create two trusts upon the death of the first spouse. The first trust would basically be funded with an amount equal to the exemption amount. This is the family trust which could be used to support the surviving spouse and the other family members. The amount used to fund the family trust would be sheltered by the estate tax exemption amount. The remainder of the assets would either be transferred directly to the surviving spouse or to a marital trust which would only support the surviving spouse. The amount used to fund the marital transfer would be sheltered by the marital deduction.
Example: Ricky and Lucy each have assets of $1.5 million and the estate tax exemption amount is still $1 million. Upon Lucy’s death, she transfers $1 million of assets to a family trust that can provide support to Ricky and other family members. Lucy is thus able to utilize her estate tax exemption amount. The remaining $500,000 of her assets will be transferred directly to Ricky. Lucy’s $1.5 million estate is thus reduced to $0 by her $1 million exemption amount (the amount transferred to the family trust) and by the $500,000 marital deduction for the transfer to her spouse. Ricky’s gross assets are $2 million (his own $1.5 million plus the $500,000 he inherited, but not the $1 million in the family trust). Ricky can now employ additional estate tax reduction techniques to get his taxable estate. Without this strategy, Ricky would have $3 million of gross assets (his and Lucy’s $1.5 million in assets) and would have to do more extensive planning to reduce his taxable estate by an additional $1 million.
Let’s Pretend We’re Married/Elect Portability
Under portability, the use of the family trust is no longer needed solely to utilize the estate tax exemption amount. The first spouse to die can transfer his unused estate tax exemption amount to the surviving spouse. This is done by electing portability on a timely filed estate tax return. If the only reason for filing the estate tax return is to elect portability, a simplified return can be filed.
Example: Fred and Wilma each have assets of $5.45 million. The 2016 estate tax exemption amount is $5.45 million. Fred dies and leaves all of his assets to Wilma. Fred’s executor files an estate tax return and claims a $5.45 million marital deduction for the transfer to Wilma. Fred’s executor also makes a portability election to transfer Fred’s unused $5.45 million estate tax exemption to Wilma. Wilma now has $10.9 million in assets. If Wilma dies shortly after, her gross estate of $10.9 million is reduced by her own $5.45 million estate tax exemption and her spouse’s unused estate tax exemption of $5.45 million.
Needless to say, the examples in this post were over-simplified but the purpose was to show the basic mechanics of the estate tax system. While the need for estate tax planning has been diminished, the need for estate planning for succession, asset protection, business continuity and many other issues is still very, very important.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.