The Return of Estate Tax Planning

Friday, December 03, 2010

I’ve been receiving a lot of questions recently about the status of the ‘death tax’ or ‘inheritance tax’. Because of the expiration of the “Bush Tax Cuts” in December, 2010, and the lack of action by our federal legislator to act on this issue, we are in the unenviable position of not knowing how (or how much) tax will apply to an individual estate.

I refer all clients to the below article, posted by the American Institute of Certified Public Accountants in their December, 2010 “CPA Bulletin”, for an excellent summary of the current status of the Federal Estate Tax. Enjoy...

IMPORTANT NOTICE:
The Return of Estate Tax Planning

The following article was prepared by American Institute of Certified Public Accountants, Inc. and appeared in the December, 2010 CPA Client Bulletin

After a one-year repeal in 2010, the federal estate tax is scheduled to return for deaths occurring in 2011 and later years. If you expect to leave a sizeable estate, you probably will want to plan for this tax. Otherwise, your beneficiaries might owe hundreds of thousands, or even millions, of dollars in estate tax.

Net Worth

At your death, your executor will be responsible for tallying all of your assets and, thus, determining the size of your estate. Those assets could include your home, other real estate, stocks and other securities, bank accounts, retirement accounts, artworks and so on. From this so-called “gross estate,” your executor will subtract outstanding debts and various final expenses (funeral costs, medical bills) to get a net value of your assets.Although the future of estate tax legislation is uncertain, you probably can assume certain tax benefits will remain in place. Bequests to charity can be deducted from your estate for tax purposes. The same is true for any amount of assets left to a surviving spouse who is a U.S. citizen.

Example 1: Len Jordan dies with $6 million of net assets. In his will, Len leaves $1 million to various charities. He leaves the rest of his estate, totaling $5 million in assets, to his wife, Pam. Therefore, Len has no taxable estate, and no estate tax is due.

Estate Tax Exemption

In addition to charitable and spousal estate tax breaks, you can assume that another exemption from federal estate tax will exist. The amount of this additional exemption in 2011 is unknown, as of this writing. Estimates generally range from $1 million to $5 million. Under current law, unless Congress acts by year-end 2010, the federal estate tax exemption in 2011 will be $1 million. (That estate tax exemption is reduced by the amount of any lifetime gifts that use the gift tax exemption, now set at $1 million.) Estate assets from $1 million to $1.25 million will be taxed at 41%; the tax rate increases to 43% for assets from $1.25 million to $1.5 million and $2 million, and so on until amounts over $3 million are taxed at 55%. (A 5% surtax will apply to certain amounts over $10 million.)

Example 2: In the previous example, Len Jordan left $5 million to his wife, Pam. Assume Pam dies in 2011 with an estate of $6 million and leaves $2 million to charity. The other $4 million, which is subject to estate tax, is left to their son Greg.

Assume that current law remains in effect, with a $1 million estate tax exception scheduled for 2011 and tax rates starting at 41%. Also assume that Pam did not use any of her lifetime gift tax exemption. The first $1 million of Greg’s inheritance will not be taxed because of the estate tax exemption. Pam’s estate will owe estate tax on the remaining $3 million at rates ranging from 41% to 55%. Altogether, Pam’s estate will owe $1,495,000 in federal estate tax. Instead of inheriting $4 million, Greg will inherit $2,505,000. (Greg may inherit even less, if state estate tax is also due.)

In these examples, Len “wasted” his federal estate tax exemption by leaving everything to Pam at his death. Consequently, Pam died with a large estate that was heavily taxed.

Example 3: With some estate tax planning, Len might have left $1 million to their son Greg and $1 million less to his widow, Pam. With a $1 million exemption, no estate tax would have been due at Len’s death. Then Pam would have died with a $3 million taxable estate, not $4 million. This simple step could have saved $550,000 in federal estate tax, which would have gone to Greg instead of going to the IRS; Pam would have had an estate smaller by $1 million at her death, and her estate would have avoided paying 55% tax on that last $1 million.

Tax Tactics

The previous examples are simplified to explain some estate tax concepts. When planning for estate tax, many professionals suggest that clients use trusts. Properly structured trusts can help reduce future estate tax and provide trust beneficiaries with creditor protection and safeguards against wealth depletion.