This article has been excerpted from Estate Planning, Wills and Trusts: for Business Owners and Entrepreneurs, available from Entrepreneur Press.
Understanding estate taxes is an important step in developing your estate plan. Most importantly, you need to remember that fewer than two percent of Americans ever pay an estate tax. Consequently, estate tax considerations should take a back seat to personal and family issues. Even if you are in the tiny minority of Americans who pay an estate tax, an estate plan that would reduce the taxes paid but fails to provide adequately for your spouse, or that puts money in the hands of children who are not yet mature enough to properly handle it, would be a disaster.
Many estate tax laws come into play, and they are complex and often convoluted. While it is helpful to have a basic understanding of the rules, you should work with an experienced estate planning professional to design an estate plan that minimizes the potential impact of estate taxes while at the same time achieving your personal and family goals.
To make it more difficult for you to understand the estate tax rules--and almost impossible for me to write this--the estate tax laws are currently in a state of flux. As recently as 2002, estate taxes could be incurred if your estate was valued at more than $1 million. In 2007 and 2008, your estate will be completely free of tax as long as the value is less than $2 million. If you die in 2009, there will be no estate taxes as long as your estate is less than $3.5 million. Should you be lucky enough to die in 2010, and assuming that Congress does not change the rules before then, there will be no estate tax no matter how large a fortune you accumulate. Then, beginning in 2011 (again, assuming Congress does not change the rules), your estate could be subject to estate tax if the value is more than $1 million. By the way, the repeal of the estate tax for one year in 2010 is somewhat of an illusion.
In addition to the $1 million, $2 million or possibly as much as $3.5 million, depending on the year of death, that can be left free of estate tax to anyone, any amount left to your spouse who is a U.S. citizen is also free of estate tax (as is anything left for the benefit of a non-citizen spouse using a specially crafted, qualified domestic trust). On top of that, any amount you decide to leave to a 501(c)(3) charity--such as your church or temple, organizations like the American Heart Association or Easter Seals Disability Services, and countless other public charities active in your community--will be free of estate tax.
The value of your estate--and the determination of whether or not your estate is large enough to be subject to estate tax--includes everything you own: the current fair market value of your house and any other real estate, your ownership interest in your business, retirement accounts or annuities, stocks, bonds and other securities, cash in the bank, artwork, jewelry and anything else you own. In addition, any life insurance benefit that is not carefully structured to avoid inclusion in your estate (by use of a carefully designed life insurance trust) will be added to the value of your estate. Finally, a detailed set of rules require you to add to the value of your estate any asset you gave away less than three years before your death, and assets over which you have effective control but not ownership.
Because these rules are highly technical, extremely nuanced and change over time, they are beyond the scope of this article. An experienced estate-planning attorney will explore these issues with you in the course of developing your estate plan.
As a general rule, inherited assets are not subject to income tax (whether or not your estate is subject to estate tax). However, certain types of assets derived from transactions that would be taxable during your lifetime may be subject to income tax under a principal known as "income in respect to a decedent." Examples of these types of assets are retirement accounts, such as IRAs, 401(k)s or profit-sharing plans, or interest payments due under promissory notes or other contractual rights.
More Forms of the Estate Tax
Another form of the estate tax, known as the Generation Skipping Tax, can come into play if you are leaving your assets directly to your grandchildren or great-grandchildren (or grandnieces and grandnephews), or to nonrelatives who are more than 37 1/2 years younger than you. This tax is designed primarily to prevent extremely wealthy families from paying estate tax only every second or third generation simply by leaving assets directly to grandchildren or great-grandchildren. It is designed to approximate the tax that would be payable if the assets had been left first to the children, and then the children left the assets to the grandchildren as part of the children's taxable estate.
The Generation Skipping Tax does not apply to the first $1 million left to your grandchildren (or great-grandchildren), so that the tax does not interfere with middle-class grandparents helping their grandchildren go to college or buy their first house. Rather than spend time trying to explain in detail a very complex tax that, quite frankly, may not be fully understood by the majority of estate planning professionals, suffice it to say that if you intend to leave substantial assets to grandchildren or great-grandchildren (or non-relatives in that age group) you should work closely with an experienced estate planning professional to avoid or minimize the Generation Skipping Tax.
Finally, a close relative of the estate tax is a separate tax known as the "gift tax." Together, the estate tax and gift tax are sometimes referred to as "transfer taxes," since they are imposed upon transfers of wealth from one person to another. Like the estate tax, the gift tax is not imposed until a certain minimum threshold is achieved. In the case of the gift tax, no tax is imposed upon the first $1 million of cumulative gifts given during your lifetime. However, to the extent such gifts are given during your lifetime, the amount that you can later leave free of estate tax in your estate will be reduced dollar for dollar.
Like most other taxes, an exception to the gift tax exists. Specifically, during each calendar year you are allowed to give gifts up to $12,000 each to any number of individuals, without using any of your $1 million lifetime gift exemption. If you are married, you and your spouse, jointly, may give up to $24,000 to each individual.
Now that you have a very basic understanding of the estate tax rules, let's take a minute to consider some of the most basic methods of reducing estate taxes.
Perhaps the most common method of minimizing estate taxes is the creation of a family trust by a married couple. Without a family trust, when one spouse dies, all the family assets would be left outright to the surviving spouse. Upon the surviving spouse's death, everything over the estate tax exemption amount (in 2007, for example, it would be $2 million) is subject to estate tax at approximately 45 percent. For a married couple with $4 million in assets, this would result in estate tax of approximately $900,000 when the surviving spouse died.
By creating a family trust, upon the surviving spouse's death assets will be treated as if they are being inherited partially from the husband and partially from the wife. Since each spouse can leave $2 million to the children free of estate tax, the entire $4 million can go to the children tax-free, a tax savings of $900,000.
Irrevocable life insurance trust
Another common tax savings tool is known as an "irrevocable life insurance trust." Properly structured, this specialized trust can literally move life insurance proceeds outside of your taxable estate. If your estate is large enough to be subject to estate tax, and you did not have a life insurance trust, the proceeds of any life insurance policy that you own will be subject to tax at 45 percent. With a life insurance trust, your estate will not pay a single dollar of estate tax no matter how large the insurance policy, even though the policy proceeds will still be available to support your family. If you have a $1 million insurance policy, your family will receive the full $1 million, rather than $550,000 after paying a 45 percent estate tax. It is worth pointing out that whether or not you have a life insurance trust, the life insurance proceeds will always be free of income tax.
Other estate tax savings can be achieved through the use of lifetime gifting of assets, or numerous specialized techniques that may apply depending on your personal circumstances.
W. Rod Sternis a partner practicing in the areas of business, tax and estate planning with Murtaugh, Meyer, Nelson & Treglia LLP, a full-service law firm in Irvine, California. Heis the author of Estate Planning, Wills and Trusts: for Business Owners and Entrepreneurs, available from Entrepreneur Press.