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Basic Estate Tax Information

The following descriptions of the estate and gift tax systems are for general information purposes only. They should not be relied upon in making estate planning decisions. They are intended only to give a general understanding of how these systems work so that the reader can have a more informed conversation with his or her estate planning attorney. The reader should consult with his or her estate planning attorney regarding his or her particular circumstances.

What is the estate tax?

The estate tax is a federal transfer tax that is imposed on estates of deceased persons. The estate tax return is due nine months after death, and the tax, if any, is also due at that time.

Most estates do not owe any tax because of the large exemptions that exist for each decedent. These exemptions have varied greatly in recent years. As recently as 2001, the per person exemption was $675,000. In 2002 and 2003, it was $1 million. In 2004 and 2005, it was $1.5 million. In 2006 through 2008, the per person exemption was $2 million, and in 2009, it was $3.5 million. There was no estate tax at all for persons dying in 2010. In 2011 and 2012, the per person exemption was $5 million. In 2013, the exemption was $5,120,000, and it is currently $5,250,000.

To get a rough idea of how much estate tax will be due in an estate, one would add up all of the property that will be subject to estate tax, as described below. Then, one would subtract all of the exemptions and deductions that are available. If the result is greater than zero, there may be some estate tax due. The tax rates are graduated. The highest marginal rate is currently 40%.

What property is subject to estate tax?

The federal estate tax is imposed on all property owned by a deceased person at the time of death. If the deceased person is a resident of Utah, this would include: (1) all property titled in his or her name; (2) all property held in the deceased person’s revocable trust at the time of death; and (3) all property held in the deceased person’s retirement plans. (For a discussion of the taxation of retirement plans, see “Retirement Plans” below.) In addition, if the deceased person owns a life insurance policy on his or her life, the death proceeds will be subject to estate tax. (For a discussion of tax issues associated with ownership of life insurance policies, see “Life Insurance Trusts” under “Advanced Estate Planning Information” on this website.) If the deceased person owns property with his or her spouse, one-half of the value of the property will generally be subject to estate tax.

What exemptions and deductions are available?

The primary exemptions and deductions are the following: First, property that passes to a surviving spouse is not subject to estate tax. Second, any property passing to charity is not subject to estate tax. Finally, as described above, each person has a $5.25 million exemption, in addition to the marital and charitable deductions. Deductions are also available for funeral and administrative expenses associated with the estate.

Thus, if a man dies with a $7.25 million estate, and leaves $1 million to his wife, $1 million to charity and $5.25 million to his children, there would be no estate tax due. The property passing to his wife would have the benefit of the marital deduction; the property passing to charity would have the benefit of the charitable deduction; and the property passing to the children would have the benefit of the $5.25 million exemption.

However, if he left $500,000 to his wife, $500,000 to charity and $6.25 million to his children, estate tax would be due on $1 million. The amounts passing to his wife and charity would escape estate tax, and the first $5.25 million passing to his children would escape estate tax, but the next $1 million passing to his children would be subject to estate tax.

Note that any property passing to a surviving spouse may be subject to estate tax in the surviving spouse’s estate at her subsequent death.

Utah Inheritance Tax

Utah does have an inheritance tax, but it is what is known as a “pick-up” tax. This means that the amount of the Utah tax is exactly equal to the state death tax credit that is available on the federal estate tax return. The result is that the total amount of federal estate tax and Utah inheritance tax is no greater than if there were no Utah inheritance tax at all. Thus, if there is no federal estate tax due, there will be no Utah inheritance tax due.

A Basic Tax-Smart Estate Plan for a Married Couple

A very basic tax-smart estate plan for a married couple is designed to take advantage of both the husband’s estate tax exemption and the wife’s estate tax exemption.

The Dilemma

Most couples want the surviving spouse to have the benefit of all of the couple’s property for as long as he or she lives. This is accomplished if all of the deceased spouse’s property passes to the surviving spouse. In that case, no estate tax is due at the first spouse’s death because of the estate tax marital deduction. As described above, when a person dies, any property that passes to a surviving spouse is not subject to estate tax.

However, property the surviving spouse receives from the deceased spouse will be subject to estate tax in the surviving spouse’s estate when he or she dies. Thus, all of the couple’s property will be subject to estate tax in the surviving spouse’s estate when he or she dies. It is true that the surviving spouse will have his or her own estate tax exemption, but the first spouse’s estate tax exemption will have been lost.

An Example

Consider the following scenario in which the husband died in 2003, when the estate tax exemption was $1 million. Assume that the couple had $4 million of assets, $2 million of which belonged to the husband and $2 million of which belonged to the wife.

If the husband left all of his property to the wife, no estate tax would have been due at the husband’s death because his entire estate received the benefit of the marital deduction.

Suppose the wife died in 2008, when the estate tax exemption was $2 million. Assume the value of the couple’s assets was unchanged at $4 million. At the wife’s death, all of the property she received from the husband would have been included in her estate, along with her own property. $2 million of the couple’s assets would have escaped taxation because of the wife’s $2 million estate tax exemption. But $2 million would have been subject to estate tax. The husband’s estate tax exemption would have been, in essence, wasted.

The Solution: A Credit Shelter Trust

The husband’s $1 million estate tax exemption could have been preserved if his estate plan left $1million to an irrevocable trust for the wife’s benefit, and the balance of his estate directly to the wife. Amounts passing to the irrevocable trust would have escaped estate taxation at the husband’s death because they would have had the benefit of his $1 million estate tax exemption. Amounts passing directly to the wife would have escaped estate taxation at the husband’s death because they would have had the benefit of the marital deduction.

The terms of such an irrevocable trust typically provide that funds in the trust are available for the wife’s needs. The standards for distributions to the wife are typically generous, but for tax reasons, they may not be unlimited. The wife may even serve as trustee of the trust and may have limited powers to determine who the remainder beneficiaries of the trust will be upon her death.

Such a trust is sometimes known as a “By-Pass Trust,” a “Credit Shelter Trust,” a “Credit Trust” or some other title, but regardless of the name of the trust, its function is essentially as just described.

At the wife’s subsequent death, amounts in the irrevocable trust would have escaped taxation in the wife’s estate because the trust would have been designed to keep those assets excluded from her estate. Other assets that the wife received from the husband, as well as her own assets, would have been subject to tax in her own estate, but she would still have had her own estate tax exemption, which could be applied to those assets.

Without the Credit Shelter Trust, only $2 million would have passed to the children free of estate tax, with the other $2 million being subject to tax. Use of a Credit Shelter Trust would have enabled $3 million of the couple’s assets to pass to their children free of estate tax (with the other $1 million being subject to tax), while giving the surviving spouse generous use of all of the couple’s funds for the balance of her lifetime.

Credit Shelter Trusts under the New Tax Law

Under the tax law enacted in December 2010, the estate tax exemption of the first spouse to die is, for the first time, “portable.” That means that, even if no Credit Shelter Trust is created on the first death, the surviving spouse’s estate may still get the benefit of the deceased spouse’s exemption.

On first glance, it may seem that this new “portability” feature renders Credit Shelter Trusts unnecessary. However, there are at least four reasons that Credit Shelter Trusts might still be attractive. Two reasons are tax related. Two reasons are not tax-related.

First, even though the deceased spouse’s estate tax exemption can be preserved through the new portability feature, it is limited to the amount of the exemption that existed at the time of the deceased spouse’s death. If a Credit Shelter Trust is used, however, all assets in the trust will escape estate taxation at the surviving spouse’s death. Thus, if the value of the trust assets grows between the first spouse’s death and the surviving spouse’s death, that appreciation will also escape estate tax at the surviving spouse’s death. Without a Credit Shelter Trust, the appreciation may be subject to estate tax.

Second, Congress and the President gave us portability, and they can take it away. An estate plan that is prepared today should not assume that “portability” will be the law when you die.

Third, an irrevocable trust can ensure that the deceased spouse’s assets will pass to his or her children upon the surviving spouse’s death. If the assets are left to the surviving spouse outright, she will be able to leave them to whomever she wants at her death.

Fourth, an irrevocable trust can provide a measure of asset protection to the surviving spouse. See “Reasons to Create an Irrevocable Trust” under “The Role of Irrevocable Trusts” on this website.

The Gift Tax

Is it possible to reduce the estate tax that will be due at one’s death by making lifetime gifts? For the most part, the answer is “no.” Just as there is a federal estate tax, there is also a federal gift tax, which is imposed at roughly the same rates as the estate tax. (Utah does not have a state gift tax.) However, there are exemptions to the gift tax that, in some circumstances, enable taxpayers to significantly reduce their estate tax liability. The federal gift tax works as follows:

Non-Taxable Gifts

Some gifts that are made during lifetime have no gift tax or estate tax consequences at all. Each year, each person can give up to $14,000 to any person (and to as many persons as he or she wants) without any estate or gift tax consequences. The recipient of such a gift does not owe income tax on the gift. Thus, a person can give $14,000 to each of a dozen (or a hundred or a thousand) persons every year, year after year, without any tax consequences. Similarly, a married couple can give $28,000 to each such person every year.

In addition, a person can pay for the medical and education expenses, without a dollar limit, for as many persons as he or she wants, without any tax consequences, as long as the funds are paid directly to the medical or educational institution. (See “Lifetime Gifting and the Time Value of Money” under “Advanced Estate Planning Information” on this website.)

Also, just as property that is left to a spouse or charity is not subject to estate tax, so property that is given to a spouse or charity during life is exempt from gift tax consequences.

Taxable Gifts

All gifts other than “non-taxable gifts” are taxable. Taxable gifts reduce the estate tax exemption that the person making the gifts will have remaining at her death dollar-for-dollar. Thus, no gift tax is due on the first $5.25 million of taxable gifts that a person makes during her lifetime. The amount of estate tax exemption that the person will have remaining at his or her death will just be reduced by the amount of the taxable gifts. However, once the taxable gifts a person has made over the course of her lifetime hits $5.25 million, gift tax will be due on any additional taxable gifts the person makes. The gift tax will be due April 15 of the following year. The gift tax must be paid by the person making the gifts, not the recipient. (Even gifts that are subject to gift tax are not subject to income tax.)

Retirement Plans

A retirement plan will generally have a beneficiary designation. On the death of the owner of the plan, the plan assets will pass to the designated beneficiary. If the owner of the plan is survived by his or her spouse, the spouse will usually be the designated beneficiary. Indeed, in many circumstances, no one else can be the designated beneficiary without the spouse’s consent.

Retirement plans may be subject to both the estate tax and income tax. The combined effect of the two taxes can mean that, in a large estate, most of a retirement plan will go to the federal government.

Retirement plan assets are included in the decedent’s estate for estate tax purposes. If the deceased person’s estate is large enough, and if it does not pass to a surviving spouse or charity, the retirement plan might be subject to the 40% estate tax.

Just as the owner of the retirement plan is required to pay income tax on distributions from the retirement plan during her lifetime, her beneficiaries must pay income tax on amounts they take out of the plan. Retirement plan beneficiaries commonly roll-over the plan and withdraw amounts from the plan over a period of years in order to take advantage of income tax deferral opportunities. The income tax will be payable as amounts are paid out. The beneficiary will receive a deduction on her income tax return for the amount of the estate tax that was previously paid that is attributable to the income reported on that return.

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