Estate Tax Planning
Philadelphia Estate Tax Planning Attorney
Without careful planning, much of your life’s legacy could be lost to estate taxes. While a simple will can provide for the transfer your estate to your loved ones, it does not have special provisions for advanced estate tax planning.
The Federal Estate tax: Exemptions & Rate
Federal estate tax laws were updated in 2015 as part of the American Taxpayer Relief Act which provides for an exemption of $5.43 million. This means that each individual can transfer up to $5.43 million in assets free of federal estate taxes. The federal estate tax exemption, also referred to as applicable exclusion amount is adjusted annually for inflation.
The taxable value of the estate is calculated by adding up all the assets owned by the individual and subtracting from that total any of his or her liabilities. Additional deductions can be taken for qualified charitable deductions as well as administrative and legal costs involved in settling the deceased’s estate.
The tax rate for estates exceeding the exemption amount is 40%. The rate is applied to the taxable estate value that is in excess of the exemption amount.
The Gift Tax: Annual Exclusion versus the Lifetime Exemption
One of the topics that cause the most confusion when discussing gift taxation is the difference between the annual exclusion from gift tax and the lifetime exemption. Part of this confusion likely stems from the fact that people think they should be able to give their property away during their lifetime with no tax consequences and partially from the difference between federal and state estate/gift tax laws.
The annual exclusion from gift tax allows an individual to give up to a certain amount tax free per person per year. In 2015, the maximum amount that can be gifted under the annual exclusion is $14,000 and this number is set by Congress. For example, this year you could give $14,000 to each of your family members or even everyone you know and incur no gift tax liability. You can repeat this pattern of giving calendar year after calendar year and incur zero gift tax liability as long as you give no more than the annual exclusion from gift tax. Any gifts exceeding the amount permitted to be made tax free under the annual exclusion would have to be reported on a federal gift tax return for the year in which the gift was made. Whether there would be any tax due on the gift depends on whether you have any available lifetime exemption.
In contrast to the annual exclusion, the federal lifetime exemption from gift tax limits the amount you can gift over the course of your lifetime and at your death. In 2015, the maximum amount you can make a gift of tax free over your lifetime or at death is $5,430,000. This number is also set by Congress and is scheduled to increase at set intervals over the next few years. Congress has linked the Federal Estate Tax and the Federal Gift Tax together to prevent people from avoiding Federal Estate Tax at their death by giving away all of their property shortly before they pass away. For instance, if you were to make $2,000,000 in gifts during your lifetime that did not qualify for the annual exclusion, this would reduce the amount you can bequeath tax free at your death to $3,430,000. If your taxable estate at your death exceeded $3,430,000, your estate would have to pay Federal Estate Tax on the excess amount at the rate of forty percent (40%).
The following example demonstrates how the annual exclusion and the lifetime exemption would apply to a gift made to a child in the amount of $100,000. First, $14,000 of that gift would qualify for the annual exclusion and could be transferred tax free. The remaining $86,000 would be applied against your remaining lifetime exemption. If you had not used any lifetime exemption previously, the amount you could pass tax free at death would be reduced to $5,344,000.
It is also important to note that the annual exclusion and the lifetime exemption do not apply to certain gifts, which can be made tax free. You may make payments directly to an educational institution or a medical provider on behalf of someone for certain qualified expenses without incurring any gift tax liability. Gifts between spouses are completely tax free, whether made during life or at death.
In addition to being able to make gifts between spouses with no Federal Gift or Estate Tax consequences, there are two other benefits available to married couples. First, married couples can engage in what is known as “gift splitting” wherein they can make joint gifts to a single person for up to twice the amount of the annual exclusion tax free. If you do decide to use gift splitting, a gift tax return should be filed to show that the gift was one half from you and one half from your spouse, even if the funds originated from a jointly held bank account with your spouse.
The second benefit available to married couple is known as “portability,” which allows married couples to essentially pool their federal lifetime and death time exemptions to pass the maximum amount tax free. For instance, if your spouse dies first and has a taxable estate of only $3,000,000, the unused $2,430,000 can be used by you at your death, permitting you to pass up to $7,860,000 tax free. This benefit is only available as long as you make the election to use portability at the death of the first spouse on the Federal Estate Tax return and the surviving spouse does not remarry.
If you have questions about how planned giving using the annual exclusion could be incorporated into your estate plan, an experienced estate planning attorney should be contacted to assist with your planning.
The Federal Estate tax: Understanding Portability
In addition to the individual exemption, married couples enjoy an unlimited deduction for transfers to one another. While this is great news for many couples who choose to leave their estate to each other, without proper planning, it can result in a forfeiture of some of the individual estate tax exemptions after the passing of the second spouse.
For example, this can occur when a husband leaves $3 million of his individually-owned assets to his surviving wife who already has $5 million herself, bringing her total net worth to $8M. The bequest to his wife is not subject to estate taxes because it qualifies for the unlimited marital deduction. After some time, the wife also passes away, leaving everything to the children. While her estate can take advantage of her individual exemption of $5.25 million, the rest her estate it could be subject to estate taxes because her husband’s individual exemption was unutilized.
To address this issue, the current estate tax law allows for “portability” of individual exemptions between spouses. Stated another way, estate tax portability enables the surviving spouse to utilize the unused portion of the first-to-die spouse’s estate tax exemption. Portability is not automatic and in order to take advantage of it, an estate tax return must be filed with the IRS within 9 months of the passing of the first spouse, even if there are no taxes due at the time.
An alternative to relying on portability is to utilize a special planning tool referred to as a credit shelter trust (also referred to as a bypass or A-B trust). If properly established, such trusts work much in the same way as portability, but do not require filing of an estate tax return after the passing of the first spouse.
A number of states impose a separate estate or inheritance taxes. While the rates are typically much lower than the federal rate of 40%, the exemption amounts are smaller as well.
Special Planning for High Net Worth Individuals
Individuals and families with significant net worth might still have taxable estates even if they take full advantage of their respective exemptions. For these individuals, there are a variety of advanced planning techniques that can be crafted to help reduce the estate tax burden, such as strategic gifting plans, life insurance trusts, personal residence trusts and grantor retained annuity trusts.
The Supreme Court’s ruling on the Defense of Marriage Act (DOMA) paves the way for same-sex couples married under state law to take advantage of all the federal privileges afforded to opposite-sex couples, including those related to federal gift and estate taxes.
Tax planning strategies are inherently complex but an experienced estate planning attorney with knowledge of estate and gift tax laws can help you establish a comprehensive plan that will allow you pass on as much of your hard-earned assets as possible to your loved ones and beneficiaries.