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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.