Understanding Estate Taxes

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.

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