Reducing Death Taxes
1. WHAT ARE DEATH TAXES?
Death taxes (also called estate taxes or inheritance taxes) are taxes on transfers of property at your death. Each person is allowed an exclusion from death tax. The following table shows the amount that can be excluded:
|YEAR OF DEATH||EXCLUSION AMOUNT|
|2006 & thereafter||$1,000,000|
In other words, if your estate is worth less than the exclusion amount in the right hand column applicable to the year of your death, your estate would not be subject to death taxes. If your estate exceeds the exclusion amount at the year of your death, your estate is subject to death taxes. However, proper planning can reduce or even eliminate the death taxes. In valuing your estate, do not forget to count life insurance and retirement benefits.
2. HOW CAN A BY-PASS TRUST HELP REDUCE DEATH TAXES?
If the value of your estate is over the exclusion amount and you are married, a common plan is to use both your exclusion amount and your spouse’s exclusion amount so that assets totaling both exclusion amounts can be protected from estate taxes. This can be done by using a special trust that is commonly called a “by-pass” or “family” trust.
The best way to illustrate how a by-pass trust can help reduce death taxes is to use an example. Let’s say the first spouse to die gives everything to the surviving spouse. There will be no death tax at the first death. This is because of a tax rule called the unlimited marital deduction. This means there is no death tax at the first death on whatever amount you give to your spouse. However, all the assets are then included in the surviving spouse’s estate. The surviving spouse has only one exclusion amount to use to reduce or eliminate death tax. If your estate is larger than one exclusion amount, a smarter plan is to use the exclusion amount of both spouse’s instead of only one. This is done by having a will or living trust that says the first spouse to die’s assets, up to the exclusion amount, are placed at his or her death into a special “by-pass trust.” The by-pass trust can allow the surviving spouse to receive the income and principal for health, education, maintenance and support. The surviving spouse can be the trustee of the by-pass trust. The important feature of the by-pass trust is that its assets, plus any growth on them, are not subject to death tax in the surviving spouse’s estate. The trust is called a by-pass trust because its assets by-pass death taxes at the death of each spouse.
Therefore, if you are married and the marital assets exceed one exclusion amount, you should consider a by-pass trust to reduce or eliminate death tax on assets passing to the children. For a couple who dies in 2000 with $1,350,000, using 2 exclusions instead of only 1 can reduce the death taxes from $270,750 to zero. For a married couple who dies in 2006 with an estate of $2 Million, using 2 exclusions instead of only 1 can reduce the death taxes from $435,000 to zero.
Only assets that are properly titled can pass to the by-pass trust. Joint assets will not. This is because joint assets automatically pass directly to the survivor, outside of the will or living trust. If too many assets are held as joint assets, it can result in the by-pass trust being under funded or not funded at all.
Assets that can pass to the by-pass trust include the following:
- Assets that are owned in the decedent’s own name.
- Assets that are owned by the decedent as a tenant in common.
- Assets that are in a properly drawn separate living trust.
- Assets that are in a properly drawn joint living trust that are treated as owned as tenants in common.
- Assets that are directed to the by-pass trust by beneficiary designation, such as a life insurance policy.
3. WHAT ARE OTHER DEATH TAX SAVINGS TECHNIQUES?
A married couple that uses a by-pass trust (described on page 6) can pass up to twice the exclusion amount tax free. A single individual can pass up to one exclusion amount free of tax. Amounts over these limits are subject to tax, starting at 37% and going to 55%. The following are some additional techniques to reduce or eliminate death tax:
- Removing life insurance to an irrevocable life insurance trust so the life insurance is not subject to death tax.
- Annual exclusion gifts. A person can give $10,000 (indexed for inflation) per person per calendar year. These remove the gift and the appreciation from the estate on the gifted amount.
- Gifts of larger amounts that use the lifetime exclusion (up to $675,000.00 in 2000 and increasing to $1 Million in 2006) to remove appreciation on the gifted amount.
- Gifts that retain control and/or income and also reduce the value of the reportable gift
- nonvoting stock
- membership interests in Limited Liability Companies
- Grantor Retained Annuity Trusts
- Qualified Personal Residence Trusts
- Charitable gifting techniques
- Outright gifts
- Charitable remainder or lead trusts
- Generation Skipping Trusts to reduce death taxes in children’s estates.
We can provide you with more details on any of the techniques described in this memorandum upon your request.
Note: This memorandum is intended as a summary of estate planning issues. It is not intended as specific legal advice applicable to all fact situations. You should consult a competent advisor to determine which estate planning techniques are best suited to your needs. The legal rules set forth in this outline are those that exist as of the date of this outline, (2000), and may change at any time.