Estate tax planning: Keeping your estate taxes to a minimum
There are two types of death taxes you should be concerned about: the federal estate tax and the state estate tax. The federal estate tax is calculated as a percentage of your net estate. Your net taxable estate is the total value of all assets you own or control, minus certain deductions, such as funeral and burial costs and charitable donations. The tax on the taxable portion of the estate is paid from the estate itself before distribution to your beneficiaries.
You need to determine whether you may be subject to state estate and inheritance taxes. Additionally, you may have a taxable estate in the future as your assets appreciate. You should regularly review your estate plan with us to ensure it reflects changes in tax laws and shifts in your circumstances.
Leveraging options for married individuals
The Unlimited Marital Deduction
Married individuals are allowed by the federal government to give an unlimited amount of assets, either by gift or bequest, to their spouse without the imposition of any federal gift or estate taxes. As a result, married couples can delay the payment of estate taxes at the passing of the first spouse because, at the death of the surviving spouse, all assets in the estate over the applicable exclusion amount will be included in the survivor’s taxable estate.
However, for individuals with substantial assets, the Unlimited Marital Deduction does not eliminate estate taxes; it merely delays them. This is because when the second spouse dies with an estate worth more than the exemption amount, his or her estate may be subject to estate tax on the amount exceeding the exemption. Meanwhile, the first spouse’s estate tax credit remains unused and, in effect, wasted. This could be avoided by filing an estate tax return after the first spouse’s passing, even if no taxes are due.
The Credit Shelter or A/B Trust
A Credit Shelter Trust, also known as a Bypass or A/B Trust, can eliminate or reduce federal estate taxes and is typically used by a married couple whose estate exceeds the amount exempt from federal estate tax, as it preserves both spouses’ exemptions.
Upon the first spouse’s death, the Credit Shelter Trust establishes a separate, irrevocable trust with the deceased spouse’s share of the trust’s assets. The surviving spouse is the beneficiary of this trust, and the children are beneficiaries of the remaining interest. This irrevocable trust is funded to the extent of the first spouse’s exemption.
Thus, the amount in the irrevocable trust is not subject to estate taxes upon the first spouse’s death, and the trust fully uses the first spouse’s estate tax credit. Special trust language gives the surviving spouse limited control over the trust assets, preventing the trust assets from becoming subject to federal estate taxation, even if the trust’s value later exceeds the exemption amount by the time the surviving spouse dies.
Controlling your home’s value through a Qualified Personal Residence Trust
A Qualified Personal Residence Trust, or a QPRT (pronounced “cue-pert”), allows you to transfer your house or vacation home at a significant discount, freeze its value for estate tax purposes, and still live in it.
With a QPRT, you transfer the title to your house to it (usually for the benefit of your family members), reserving the right to live in the house for a specified number of years. If you live until the end of the specified period, the house (as well as any appreciation in its value since the transfer) passes to your children or other beneficiaries free of any additional estate or gift taxes.
After the end of the specified period, you may continue to live in the home, but you must pay rent to your family or designated beneficiary to avoid including the residence in your estate. This may be an added benefit, as it further reduces the value of your taxable estate. However, the rent income has income tax consequences for your family. If you die before the end of the period, the full value of the house will be included in your estate for estate tax purposes. In most cases, you are no worse off than you would have been had you not established a QPRT.
A further benefit of the QPRT is that it also serves as an excellent asset and creditor protection vehicle because you no longer technically own the property once the trust is established.
Avoiding estate taxes on life insurance
While life insurance proceeds are received by your loved ones free of income taxes, they are counted as part of your taxable estate and therefore your loved ones can lose over forty percent of your policy’s value to federal estate taxes. An Irrevocable Life Insurance Trust keeps the death benefits of your life insurance policy outside your estate, so they are not subject to estate taxes.
Forming a Family Limited Partnership
A Family Limited Partnership (FLP) is a form of limited partnership among family members that includes both general partners (who manage the partnership) and limited partners (who are passive investors). General partners bear unlimited personal liability for partnership obligations, while limited partners have no liability beyond their capital contributions. Typically, the partnership is formed by older-generation family members who contribute assets in return for a small general partnership interest and a large limited partnership interest. The limited partnership interests are then transferred to their children and/or grandchildren, while the general partnership interests that control the partnership are retained.
The FLP has a number of benefits: transferring limited partnership interests to family members reduces the taxable estate of the older family members while they retain control over the investment’s decisions and distributions. Because limited partners cannot control investments or distributions, they may be eligible for valuation discounts at the time of transfer, which reduces the value of their holdings for gift and estate tax purposes. Lastly, a properly structured FLP can provide creditor protection because the general partners are not obligated to distribute partnership earnings.
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