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 2001, and further changes were expected to occur before the end of 2009, but did not. So for 2010, we are in a period of tax uncertainty. The 2001 tax bill temporarily repeals the federal estate tax for 2010, but under the current law the repeal is short lived, as in 2011 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.
Every person is entitled to an exclusion from federal estate taxes to protect his or her estate from estate taxes. Beginning in 2003, this exclusion has risen from $1,000,000 for persons dying in 2003; to $1,500,000 in 2004 and 2005; $2,000,000 in 2006, 2007 and 2008; and to $3,500,000 in 2009, slipping down to $1,000,000 in 2011 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. An important planning technique is to ensure that the exemption of the spouse who dies first is not wasted.
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 planning opportunity to shelter assets from estate tax when the first spouse died may have been missed.
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 45%. Unless changed by new legislation, the estate tax rate increases to 55% in 2011 and beyond. The executor 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.
Unless changed by new legislation, for persons dying in 2010, there is no federal estate tax. Many expected the 2009 rules to be extended to 2010 and possibly thereafter. In fact, Congress could still extend the 2009 rules by changing the rules mid-year or retroactive to January 1, 2010. Any retroactive change will raise issues of constitutionality and likely cause litigation for years to come.
The 2010 year estate tax repeal will not necessarily be beneficial for estates of many taxpayers dying in 2010. In conjunction with the repeal of the estate tax, beneficiaries inheriting assets from an estate of a person dying in 2010 will take a "carryover basis" in the asset equal to the basis the decedent had in that asset rather than a "stepped up basis" equal to the value on the date of death. Upon a subsequent sale of the appreciated asset, the beneficiary will pay income tax on the sale value less the carryover basis. There are two adjustments to the new carryover basis rule: The basis of appreciated property owned by the decedent may be increased by up to $1.3M (but to not more than the fair market value of the assets) as well as by certain loss carryovers. Secondly, in addition to the first adjustment, property passing to a surviving spouse (whether outright or in a certain qualified trust for the spouse) can qualify for up to a $3,000,000 increase in basis. In both cases, the basis adjustment is allocated among the assets by the executor of the estate.
So, for the estate of a person dying in 2010, rather than being liable for estate taxes, the estate and its beneficiaries may end up being liable for the higher income taxes instead, due to the imposition of the carryover basis rules.
There will be numerous challenges to handling the estates of persons dying in 2010, as well as to preparing estate plans for clients for a future which is so uncertain. For estate planning clients, we will want to establish estate planning documents and asset structures which consider the 2009 and 2011 estate tax rules, as well as the 2010 carryover basis rules, in case the client dies in 2010. 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.
For instance, in the case of a married couple with appreciated assets, we will want to ensure that the spouse who dies first has a Will that creates a trust for the surviving spouse that qualifies for a potential step up in the basis of the assets, yet at the same time ensures if or when the estate tax is back in place, that the trust assets qualify for estate tax exclusion on the death of the surviving spouse.
With the uncertainties of the current estate tax and carryover basis 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 the 2001 federal estate tax law changes. 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.
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 45% (35% in 2010 and 55% in 2011 and beyond) 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 $1,000,000 lifetime exclusion from gift taxes available to every individual. Although the federal estate tax was repealed for 2010, the federal gift tax remains in place for 2010.
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 2009 was $3,000,000 to $5,000.000 (the same as the federal estate tax exemption) and the GST Tax rate was 45%. For 2010, the GST Transfer Tax is repealed, springing back into effect in 2011, with an exemption of $1,000,000 and 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.