Regardless of which estate planning documents you decide on, all individuals with large estates need to understand the estate and gift taxes and how both taxes may apply to their estates. The gift tax is a tax on all gifts made, whether outright or in trust that take effect during a person's lifetime (inter vivos gifts). The estate tax is a tax on all gifts/transfers, whether outright or in trust that take effect at the grantor's death (testamentary gifts). Unless there is an exception, tax must be paid on all inter vivos gifts and testamentary gifts.
When you die, whatever assets you own at the time of your death are part of your gross estate. These assets include personal property, such as cars and computers; liquid assets such as savings accounts and mutual funds; real estate, retirement accounts, and life insurance. Life insurance proceeds, while not taxed as income to the recipient, are indeed calculated in the value of the decedent's gross estate. Your taxable estate is equal to the gross estate minus funeral and burial expenses paid out of the estate, debts owed at the time of death, the value of property given to a spouse, the value of property given to a qualifying charity, and state death taxes.
Tax must be paid upon the transfer of the taxable estate unless some exception applies. Under Federal tax law, one spouse can give an unlimited amount of property to a U.S. citizen spouse during lifetime or after the grantor's death*. In tax talk, this ability to give to a spouse without estate tax consequences is called the Unlimited Marital Deduction. Thus, estate tax can be completely avoided simply by giving the entire estate to a surviving U.S. citizen spouse. However, upon the death of the unmarried second spouse, the unlimited marital deduction is no longer available. Intervivos and Testamentary gifts to other loved ones are shielded from tax only by the unified credit.
The unified credit is just what the name implies: a credit against the gift or estate tax that would otherwise have to be paid. In the year 2024, this credit is $13,610,000** per person. The first $13,610,000 of each person's estate is shielded from Federal estate tax. If the estate exceeds $13,610,000, it will be required to pay Federal estate tax on the excess, up to a maximum rate of forty percent. Combining their unified credits in 2024 allows a married couple to shelter up to $27,220,000.
In addition to the federal estate tax, most states have their own estate tax. For example, Vermont assesses a 16% estate tax on all of the decedent's assets over $5,000,000.
A General Explanation of the Current Estate and Gift Tax
How do you minimize the estate tax if your estate is or is expected to be over the unified credit in effect in the year of your death? One option is to give property away during your lifetime, thereby reducing the value of your estate until it is under the tax exclusion amount. However, the tax code places severe limits on nontaxable gifts. Gifts outside these limitations will be subject to a gift tax, which will be imposed once the estate exceeds the unified credit.
The current (2024) annual gift tax exclusion that a Grantor can give to any one individual is currently $18,000. A married couple can combine their annual exclusions and gift $36,000, gift tax-free, to any one individual. In addition to the annual exclusion, larger amounts to pay educational or medical expenses directly to the qualified provider are nontaxable events. Annual exclusion gifts can only be made in trust if the trust includes specific limitations on the trust and gives the beneficiaries specific rights known as crummy powers. Sometimes, gifts to 529 college savings plans are exempt from the gift tax.
A married person's most powerful estate tax avoidance mechanism is ensuring both spouses' full unified credits are utilized. How do you make sure that both unified credits are utilized? This can be accomplished in two ways. The easy way is for the first spouse to die to leave an amount up to the unified credit directly to his/her kids or third party. Although this option eliminates the estate tax problem, it leaves the surviving spouse without access to the assets.
The second option is to leave the amount up to the unified credit to the spouse in trust, with the remainder going to the grantor's children or a third party. The surviving spouse's interest must be restricted to qualify a trust for the unified credit. This type of trust is known as a credit shelter trust, sometimes called a bypass or A/B trust. Depending on the grantor's goals, the trust can be set up as a Qualified Terminal Interest Protection Trust (“QTIP”).
The Power Of The Joint Credits Is Illustrated As Follows:
Remembering the basics of the unlimited marital deduction and the unified credit discussed above, consider the following two examples:
Example 1:
No tax planning. Let's say that Husband (H) has a taxable estate of $14,610,000. Wife (W) has assets in her own right worth $12,610,000. H dies in 2024 with a simple will, giving all his property to W. W takes tax-free under the unlimited marital deduction. W dies the following month with a will, giving all of her property equally to her two children, A and B. Upon her death, W's taxable estate is $27,220,000. The unified credit ensures that W's estate does not need to pay tax on the first $13,610,000. However, an estate tax will be levied on the other $13,610,000 not protected by the unified credit.
Example 2:
Credit Shelter Trust. Assume the same facts as above; however, this time H has seen an estate planning attorney and has executed a will containing a credit shelter trust. It is called a “testamentary” trust because it is created by language in a will. Basically, H's will says that $13,610,000 goes into a trust for the benefit of the children. Everything above that amount goes outright to W, and no strings are attached. The trust instructions give W access to the trust income and limited access to the trust principal during her lifetime. When W dies, all remaining trust assets go to the children.
Here's what happens, tax-wise, if H dies in 2024 after executing a testamentary credit shelter trust. The $1,000,000 given to W outright is not subjected to estate tax. It is protected by the unlimited marital deduction. The other $13,610,000 put in the trust is not considered to be a gift to W; rather, it is a gift to the children and, therefore, not protected by the unlimited marital deduction. However, it is shielded from tax up to the amount covered by the unified credit-$13,610,000.
Unlike in the previous scenario, H's unified credit has been used well. Upon the second spouse's death, the $13,610,000 trust proceeds go to the children tax-free, protected by H's unified tax credit. But W's estate has an additional $1,000,000, giving her a total of $13,610,000 [Remember, in this scenario, W took outright from H and her separate property, which was owned before H's death.]. If W dies a month later, as in the first example, using her unified credit, she can also give the children this additional $13,610,000 tax-free. Thus, $27,220,000 is passed tax-free to the children, making good use of both H and W's unified credits. Tax on $13,610,000 has been completely eliminated!
For unmarried people and married people with estates larger than both of their unified credits, there are several other options available to reduce or eliminate the estate tax, including, but not limited to, the following:
Charitable Trusts – A charitable trust is a legal entity set up to hold and manage assets for charitable purposes. Charitable Trust are primarily use for estate tax planning because if drafted correctly, the trust can be used to reduce or eliminate estate taxes and/or income taxes.
- Charitable Remainder Trust – A Charitable Remainder Trust (CRT) is a tax-exempt irrevocable trust that provides income to beneficiaries (often the grantor or other designated individuals) for a specified period. The remaining assets ultimately benefit one or more charitable organizations.
- Charitable Lead Trust – A Charitable Lead Trust (CLT) is an irrevocable trust that provides income payments to one or more charitable organizations for a specified period. The remaining assets eventually pass to non-charitable beneficiaries, such as family members or designated heirs.
Intentionally Defective Grantor Trusts – An Intentionally Defective Grantor Trust (IDGT) takes assets outside the grantor's estate for estate tax purposes but is drafted so that income generated from the trust is taxable to the grantor. An IDGT allows the grantor to gift or sell assets to the trust and any appreciation grows tax free. Payment of income tax by the grantor allows the trust principal to grow and is not considered an additional taxable gift to the beneficiaries.
A Spousal Limited Access Trusts (SLAT) – is an estate tax planning tool that allows one spouse (the donor spouse) to transfer assets into an irrevocable trust for the benefit of the other spouse (the beneficiary spouse), as well as potentially other family members, while still maintaining some access to the trust assets. SLATs are commonly used to take advantage of estate tax exemptions and provide financial security for the beneficiary spouse and family.
Irrevocable Life Insurance Trusts – An Irrevocable Life Insurance Trust (ILIT) is a trust created to hold a life insurance policy. The purpose of an ILIT is to move money out of the grantor's taxable estate and provide liquidity at death. In large taxable estates, the cash proceeds may be used to pay federal and/or state level estate taxes. In smaller estates, the insurance policy proceeds can be used to provide for family members and satisfy outstanding debts. This type of trust is particularly useful for family-owned business to create liquidity to continue the business or to allow family members to buy each other members out of their shares.
Qualified Personal Residence Trusts – A Qualified Personal Residence Trust (QPRT) is an irrevocable trust used for estate tax planning to hold a residence or vacation home. The grantor gifts the home to a QPRT but retains the right to live in the house for a stated period of time. At the end of the term, the home is transferred to the grantor's children or other named beneficiaries. In this way the grantor removes the home from his or her taxable estate and any appreciation in the property grows tax free.
Grantor Retained Annuity Trusts – A Grantor Retained Annuity Trust (GRAT) is used to remove assets out of the grantor's taxable estate by gifting the assets to family members without having to use any portion of the federal estate tax exemption. In exchange for the gift to the irrevocable trust, the grantor retains the right to an annuity for a specific term of years.
Generation-Skipping Transfer trust – A GST trust, also known as a Generation-Skipping Transfer trust, is a type of trust designed to minimize or avoid the generation-skipping transfer tax (“GST”).
Credit Shelter, Bypass, Qualified Terminal Interest Property Trusts – Credit Shelter, Bypass, Qualified Terminal Interest Property Trusts are trusts designed to minimize or avoid the federal or state estate taxes. Family Limited Liability Companies and Family Limited Partnerships.Credit Shelter Trusts (Bypass Trusts)
Limited Liability Company (LLC) – A Limited Liability Company (LLC) is a business structure that combines the limited liability protection of a corporation with the pass-through taxation benefits of a partnership. LLCs are flexible entities commonly used for various business and investment purposes. Like Family Limited Partnerships (FLPs), LLCs may offer valuation discounts for estate tax purposes. Because of the transfer restrictions placed on the membership interests, the IRS allows valuation discounts on the LLC member interests, allowing an individual to gift or sell the discounted LLC memebership interests to junior family members over time, leveraging annual gift tax exclusions and the lifetime gift tax exemption.
Family Limited Partnership (FLP) – Is a legal entity created by family members to own and manage assets collectively. Because of the transfer restrictions placed on the shares of the limited partners, the IRS allows valuation discounts on the limited partnership interests, allowing an individual (general partner) to
gift or sell the discounted limited partnership interests to junior family members over time, leveraging annual gift tax exclusions and the lifetime gift tax exemption.
Corporations – A corporation is a legal entity that is separate and distinct from its owners (shareholders). It is created under the authority granted by law and has many of the same rights and responsibilities as an individual. Corporations can own property, enter into contracts, sue or be sued, and conduct business operations. One of the key features of a corporation is limited liability, which means that shareholders typically are not personally liable for the debts and obligations of the corporation beyond their investment in the company (unless they have personally guaranteed the debts).
**Without congressional intervention the current unified credit is set to sunset on December 31, 2025 at which time the unified credit will come down to $5,600,000 +/-.
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