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As important as it is to plan to reduce taxes, these strategies should never come before having your assets go to meet your other desires. If you want to arrange your financial affairs in such a way that might generate estate tax, yet allow you and your spouse complete control or to benefit someone in particular, that's all right.

Note: Special rules apply to a spouse who is not a U.S. citizen. You should consult an attorney experienced in this area of the law.

Basics of Estate Taxes

The federal government has set up a tax system to collect estate tax when you die, if you have an estate over a certain amount. The tax rates on estates can be as high as 40% and may potentially make the federal government one of your major beneficiaries if you die with a sizable estate.

For tax purposes, your taxable estate is defined as your estate (including everything you own, such as your home, personal property, retirement plans, joint property, life insurance, etc.) less expenses and certain deductions and exemptions (see How Big Is Your Estate below).

When determining your taxable estate, you are allowed to deduct any debts the estate has (excluding federal estate tax), any expenses paid to the executor, attorneys, or accountants in settling the estate, and qualified charitable donations. If the state charges a state death tax, there is a deduction for amounts paid for state death taxes (see the section State Death Taxes and Gift Tax).

How Big Is Your Estate?

A person's estate consists of all the property he or she owns at the time of his or her death. Property is widely defined to include anything that can be owned. In addition to such items as cash, personal property, securities and real estate, property consists of things like life insurance, accrued pension benefits, employee stock options, balances in 401(k) and savings plans, and powers over a trust (general powers of appointment). This list is representative and not all inclusive.

IMPORTANT NOTE: It is important to determine if estate tax will be due at your death, and if your estate will have enough money to pay the tax. If there are insufficient funds available, there are strategies available, such as using life insurance, to provide liquidity to your estate.

The Unlimited Marital Deduction

One of the easiest ways to postpone and minimize or eliminate estate taxes is to take advantage of the unlimited marital deduction. At death, any property that is transferred to a spouse is deducted from your taxable estate. In many cases, this is how you can postpone tax until the surviving spouse dies. There are a few limits on this deduction, so if you are thinking of leaving assets to your spouse in a trust, you will need to ask your attorney if you will be jeopardizing this important deduction.

However, you are also allowed to transfer a certain amount of assets at your death to anybody, free of estate taxes (see Estate Applicable Credit Amount, below). It is important to take advantage of this applicable credit amount, so you may not want all assets to pass to your spouse using the unlimited marital deduction. Consider the use of a bypass trust to take advantage of each spouse's applicable credit amount (see the section Estate Planning Strategies).

IMPORTANT NOTE: The unlimited marital deduction does not apply to transfers to a spouse who is not a U.S. citizen. Special rules have to be followed. If this applies to your spouse, find an attorney that is knowledgeable in this area of estate planning.

Estate Tax Changes over Time

In 2001 major changes to federal transfer taxes were made. A tax-cut package was implemented over a ten-year period, and eventually repealed the estate tax in 2010. Then in 2011 the estate and gift tax exemption (per individual) was set to $5 million, with a top tax rate of 35 percent. Now in 2019 the highest tax bracket is 40% and the estate and gift tax exemption (per individual) was increased to $11.4 million. With these multiple changes in estate tax laws, it is very important that you consult a trusted and knowledgeable estate and tax professional to help you in your planning decisions.

SUGGESTION: Any estate planning that you did before 2010 should be re-examined in light of this tax law change. Revisit wills and trust documents to determine if changes are required. Married couples should ensure that they have enough assets in their own names in order to take full advantage of the higher exclusion amounts.

Estate Applicable Credit Amount

Your estate tax situation will depend on how large your estate is when you die. The law allows you to transfer a certain amount of assets free of estate and gift tax. This amount is called the "applicable exclusion amount." In 2020 every person may transfer assets at death valued in the aggregate at $11.58 million ($11.4 million in 2019) free from estate tax. For lifetime transfers— i.e., gifts —the applicable exclusion amount is the same. The total amount used during your lifetime against your gift tax in effect reduces the credit available to use against your estate tax.

The Impact of the Portability of the Federal Estate Tax Exclusion – Example #1

Assume a husband and wife each have $11 million of exclusion available. The husband dies with $3 million of assets in his estate, which he is leaving to the couple’s children. Because the $3 million is less than the $11 million, no federal estate taxes are actually due and no return is required. However, if the husband’s estate files an estate tax return and makes the election to transfer the DSUE, the wife’s exclusion is increased by $8 million. Now the wife’s estate has $19 million available to transfer to the heirs free of federal estate tax.

You may say, ‘that all sounds great, but there is no way my spouse and I will ever have over $22.8 million.’ That may be true, but the current exclusion is scheduled to revert back to the pre-2017 amount ($5 million adjusted for inflation) on January 1, 2026. This should amount to roughly $6 million after the expected inflation adjustments. Also the exclusion has been raised and lowered by Congress many times in the past and could be scaled back again any time.

The Impact of the Portability of the Federal Estate Tax Exclusion – Example #2

Again, assume a husband and wife each have an $11 million exclusion. The couple has done no estate planning. The husband has a $3 million IRA, his wife is the beneficiary, and they hold their remaining $6 million estate jointly. He dies with a $6 million estate ($3 million IRA plus half of the joint assets), which will all pass to the surviving spouse. Since transfers to spouses are free from estate tax, the settling of the husband’s estate will not use up any of his $11 million exemption, and no federal estate tax filing is required.

The surviving spouse now has the entire $9 million of assets in her estate. Now assume that in 2021 Congress lowers the exclusion to $5 million (keeping the tax rate at the current 40%). The wife dies in 2021. Her estate will owe $1.8 million in estate taxes ($9 million less $5 million times 40%). However, if the husband’s estate had filed an estate tax return and made the election to transfer the DSUE, the wife’s exemption would be $16 million (the DSUE of $11 million plus her exemption of $5 million), and no estate tax would be due.

Other Important Considerations of the Portability Election

An added benefit of the portability election is a “relaxing,” if you will, of the diligence and complexity couples need to maintain with regard to each spouse’s estate value to ensure no exclusion is wasted. Before portability, the couple in Example #2 would most likely have established living trusts to hold their assets, and would have balanced assets between the trusts to ensure each could use up all or a large portion of the exclusion if they were to die first. They may have been able to avoid the estate tax at the death of the surviving spouse without filing an estate tax return; however, this strategy would have required legal documents, valuation monitoring, and possible transfers back and forth during lives to maintain optimal estate values for each of them on an ongoing basis. Then there would also be ongoing income tax compliance after the first death for the irrevocable trusts that would remain after the estate closing.

One final important factor to consider is that under recently finalized IRS regulations, there will be no reduction or claw back of any transferred exclusion should the basic exclusion amount be reduced sometime in the future.

Surviving spouses should seriously consider the potential advantages of filing Form 706 to make the portability election. Normally, Form 706 is due nine months from the date of death with a six-month automatic extension available. However, if the 706 is filed only to elect portability, it can be filed anytime on or before the second anniversary of decedent’s death.

The passing of a spouse is a difficult time and requires the assistance of your advisory team. Discuss the portability election with your tax team now to determine if this strategy is right for you.

Gift Tax

It may seem easy to avoid estate tax. Why not simply give away everything you own right before you die (or give it to your spouse and have him or her give it away before he or she dies)? Well, the government is one step ahead of you. There are also taxes to pay when making gifts. In fact, these taxes are part of the same tax, called the Transfer Tax. In essence, the government will try to tax you every time you transfer an asset to someone, no matter whether you are alive or dead at the time.

The gift tax is a tax on the fair market value of assets transferred as gifts whether the gift is direct or indirect, and whether the gift is in trust or otherwise. Payments for support (paying for food, clothing, shelter, court-ordered child support payments, etc.) for your minor children for which you are legally obligated are not considered gifts.

There is an applicable credit amount which allows you to transfer a certain amount of assets during your lifetime free of gift tax. The total amount of assets that you can transfer during your lifetime is known as the applicable gift tax exclusion amount and is at $11.4 million. There are also annual exclusions discussed below. The gift tax rates are the same as the estate tax rates. An informational gift tax return needs to be filed for gifts greater than the annual exclusion.

Gift Tax Exclusions

There are four very important exclusions to the gift tax that allow you to make tax-free lifetime transfers without ever using your gift tax applicable credit amount. By doing so, your estate is reduced when you die, and your family ends up with cumulatively more assets. These exclusions are:

• gifts to qualified charities,
• gifts to your spouse (special limits apply if your spouse is not a US citizen),
• gifts for medical or educational expenses where the transfers are made directly to the institution and not to the beneficiary, and
• annual exclusion gifts.

Annual Exclusion Gifts

Every person is allowed to give any individual up to $15,000 in 2020 in gifts (same as in 2019). This is called your Annual Exclusion. In 2020 you can give $15,000 to one hundred different people each year and have all the gifts covered under this exclusion. You are not allowed to carry over an annual exclusion from one year to the next. For example, you and your spouse cannot give your sister $30,000 this year and claim a full annual exclusion because you did not give her anything last year.

IMPORTANT NOTE: Gifts that qualify for the annual exclusion must be "present interest" gifts versus gifts of a "future interest". This means the recipient must be able to use the assets immediately, versus restricting their "present use", for example, by putting the assets in a trust for future transfer.
However, there are methods of qualifying gifts in trust for the annual exclusion, e.g., a section 2503(b) trust established for a minor and adding trust provisions that give beneficiaries certain withdrawal rights. Ask your estate planning professional for a more detailed explanation of these methods.