Estate, Gift & Income Tax Planning
An effective estate plan seeks to minimize estate, gift and income taxes within a client's overall planning objectives. Complicating the client's ability to minimize tax exposure are constant revisions to tax laws and uncertainty about changes in tax rates, exemption amounts and the temporary nature of certain tax provisions.
Federal Estate Tax
The federal estate tax regime underwent dramatic change in 2010, with an increase in the estate tax exclusion, a decrease in the estate tax rate, and the introduction of a "portability" concept for spouses. The 2010 tax bill changes are temporary in nature, as in 2013 the estate tax reverts back to the 2001 rules. While this uncertainty may cause anxiety, proper estate planning should provide flexibility to anticipate changes in the law.
The gross estate is the starting point in computing estate taxes. All assets of a decedent are valued as of the date of death to make up the gross estate. This includes assets such as life insurance proceeds, IRAs or other retirement plan benefits, jointly owned property and assets with transfer on death registrations. It makes no difference if assets are distributed by the Will, beneficiary designation, revocable trust or otherwise.
Deductions for property passing to a surviving spouse or charities, administrative expenses, and state death taxes reduce the size of the gross estate. The amount remaining is known as the taxable estate, and serves as the basis for computing estate tax.
Every person is entitled to an exclusion from federal estate taxes to protect his or her estate from estate taxes. This exclusion is $5,000,000 for 2011 and 2012, slipping down to $1,000,000 in 2013 unless changed by new legislation. The exclusion is first reduced by any taxable gifts made during a person's lifetime; any remaining amounts reduce the taxable estate.
The surviving spouse may receive an unlimited amount of assets from his or her spouse without incurring estate tax, known as the "marital deduction", thereby reducing or completely eliminating the taxable estate. Assets may be transferred to the surviving spouse through the Will, or by naming the surviving spouse as a beneficiary of life insurance policies or retirement accounts. Jointly owned assets will automatically pass to the surviving spouse by operation of law. If all property passes to the surviving spouse, no estate tax will be due. This property, if still owned by the surviving spouse at his or her death, will be included in the surviving spouse's gross estate.
A new concept included in the Tax Relief Act of 2010 is "portability", or the ability of a surviving spouse to add the balance of the deceased spouse's unused federal estate and gift tax exemptions to his or her own exemption. The portability election can be made by the deceased spouse's executor on a timely filed federal estate tax return. Traditionally, any unused exemption at death was lost permanently, potentially resulting in payment of unnecessary estate tax and a lost planning opportunity. With portability, it may be possible to minimize some of the harm done by failing to properly plan.
For example, if a husband dies in 2011 or 2012 having used only $2 million of his $5 million exemption, the surviving spouse can then add his unused exemption of $3 million to her own $5 million exemption, giving her a total of $8 million that she can pass free of federal estate tax to children at her death if she were to pass away in 2011 or 2012.
Portability is a positive development for estate tax planning but is no substitute for an effective estate plan. First, it may be advantageous to utilize the full exemption amount at the first spouse's death in order to remove appreciation in the assets from the surviving spouse's estate. Second, as currently contemplated, portability is limited only to 2011 and 2012 unless Congress changes the law again. Absent further action, starting in 2013 portability expires and the surviving spouse loses any exemptions carried over from his or her deceased spouse.
Assets left to qualifying charities entitle an estate to a charitable deduction from the gross estate. A charitable contribution may take several forms, including a specific bequest of money to a charity in a Will, naming a charity as the beneficiary of an IRA or other retirement account or leaving the charity a percentage of the estate. Certain trusts having a charitable and non-charitable beneficiary should also qualify for a charitable deduction based upon anticipated amounts passing to charity.
If reducing the gross estate by the exclusion from estate taxes and the marital, charitable and other deductions does not eliminate the taxable estate, any remaining amounts are taxed at a current rate of 35%. Unless changed by new legislation, the estate tax rate increases to a top rate of 55% in 2013 and beyond. The executor normally pays estate taxes from the assets of the estate. In most circumstances, beneficiaries are not taxed when they receive the funds. An important consideration in estate tax planning is determining which assets will be used to pay the estate tax, and how estate taxes will be apportioned among beneficiaries, some of whom may inherit pre-tax assets, such as IRAs or tax-deferred annuities, that will incur income taxes if withdrawn from to pay estate taxes.
Beneficiaries inheriting assets from an estate will take a "stepped up basis" equal to the asset's value on the date of death. Upon a subsequent sale of the asset where its value appreciates, the beneficiary will pay income tax on the sale value less the stepped up basis.
For estate planning clients, we will want to establish estate planning documents and asset structures which consider the current and present 2013 estate tax rules. The key will be to organize an estate plan that considers all the potential scenarios and provides the executor with the authority and ability to make various elections and choices at the death of the client, when we will know the values and basis of the assets, and hopefully, the rules that apply.
With the uncertainties of the current and future estate tax rules, we recommend that you arrange for a careful review of your current estate plan to make sure the plan addresses all the different scenarios that could be applicable, and provides your executor with all the available options and opportunities for saving estate and income taxes.
New York Estate Tax
New York also imposes its own estate tax, using the federal gross estate discussed above as its starting point. An important distinction between the federal and New York estate tax is that New York does not conform to any post-2001 federal estate tax law changes. Subsequently, the New York exclusion from estate tax is presently $1,000,000. As a result, an estate with no federal estate tax liability may owe New York estate tax if it exceeds the New York exclusion but is less than the federal exclusion. The New York estate tax rate increases as the size of the estate increases, from a rate of 5.6% for estates over $1,000,000 up to a maximum rate of 16%.
Unlike the federal government, New York does not impose a gift tax (see below). This provides individuals willing to make significant lifetime gifts with the potential to reduce New York estate tax paid by their estate by giving away assets prior to death. Extreme care must be taken in the selection and distribution of assets to be gifted, so consulting with an estate planning attorney is crucial.
Gift Tax
Gifting assets to children, grandchildren or others reduces an individual's gross estate, thereby saving estate taxes. To prevent someone from avoiding estate taxes completely by giving away all of his or her assets during lifetime, the federal government imposes a gift tax at a current rate of 35% on any gifts not qualifying for the annual, lifetime, charitable or marital gifting exclusions. Spouses may make unlimited gifts to one another without incurring gift taxes. This gifting between spouses may be important to equalize assets owned by each spouse in planning for estate taxes. Additionally, gifts to qualifying charities are exempt from gift taxes.
Beyond gifts to spouses and charities, individuals may gift up to $13,000 per year per person without incurring gift tax. The exclusion increases to $26,000 per year per person if a spouse joins in the gift. The annual exclusion of $13,000 is increased for inflation, but only in increments of $1,000, so it will increase over time. Where an individual makes gifts exceeding the annual exclusion, any excess will reduce the $5,000,000 lifetime exclusion from gift taxes available to every individual. Similar to the federal estate tax, for 2011 and 2012 a portability concept applies to unused lifetime exclusion at death, so a surviving spouse may add any unused lifetime exclusion of the deceased spouse to his or her own exclusion.
Generation-Skipping Transfer Tax ("GST Tax")
In addition to estate and gift taxes, there is a GST Tax on certain transfers that skip a generation, either by outright transfer or through a trust. The GST Tax exemption for 2011 and 2012 is $5,000,000 (the same as the federal estate tax exemption) and the GST Tax rate is 35%. Similar to the estate tax, absent further changes in the law the GST tax exemption returns to $1,000,000 in 2013 with a 55% tax rate.
Income Taxes for Estates and Trusts
Unfortunately, income taxes do not end with death. Planning to minimize potential income taxes on income earned by an estate is an integral part of the estate administration process. Among the issues to identify are:
- Where and how to invest estate proceeds during administration
- Whether or not to take executor or trustee's commissions
- Whether administration expenses should be taken on the estate tax return or income tax return for the estate
- If the estate will need to make payments of estimated income tax
- When to pay administration expenses to offset income of an estate
- Selecting a fiscal year end for the estate or revocable trust
- When to make distributions and fund trusts
A trust will either pay income taxes on its income at trust tax rates or the income will be taxed to the trust's beneficiary. Where the income is taxed depends upon whether the trustee distributes income to trust beneficiaries or reinvests income within the trust. Except for the lowest tax bracket, income tax rates for trusts are similar to individual tax rates; however, the highest marginal rate for trust income begins at a much lower taxable income threshold. Proper planning for income taxes involving trusts requires an understanding of the beneficiary's living needs and income tax situation, the goals espoused for the trust by the trust's creator, and consideration of the property held by the trust.