ESTATE TAX EXEMPTIONS

Newspaper and internet articles throw around the phrases “taxable estate”, “credit shelter trusts”, “unified credit”, “exemption amount”, and “marital exclusion”. But what do these phrases mean? And do they apply to you?

In general, in 2006 any US citizen or resident is entitled to give at their death up to $2,000,000 without incurring any transfer taxes. They can use up to $1,000,000 of it during their life and to the extent they do not use it during their lifetime, it can be used at their death to save on transfer taxes. For example, if someone gives $750,000 to his son during his life, he only has another $1,250,000 tax free at this death. This limit is known as the exemption amount and the tax credit for this amount is known as the unified credit (on your estate tax return you do not deduct th exemption amount. You calculate your taxes on the full amount and then deduct the unified credit from that tax).

In addition, you can give your spouse an unlimited amount. Transfers between spouses are transfer tax free and this is known as the marital exclusion or exemption.

That seems pretty straight forward but it gets slightly more complicated. The exemption amount is gradually increased over the years, is eliminated in 2010 and then “sunsets” back to earlier levels. In addition that tax rate is gradually decreased and then “sunsets” back.

Several things should strike you immediately. First of all, in 2010, the richest man in America could die, leave everything to his friends and pay zero estate taxes. However, if he is “unlucky” enough to live until 2011, not only will he have to pay taxes on more money then if he died in 2009 (the exemption amount drops back or “sunsets” to $1,000,000) but the tax rate is significantly higher.

Secondly, the gift tax exemption caps at $1,000,000. If you make gifts during your lifetime exceeding $1,000,000, you will have to pay gift tax, even if you have not reached your estate tax exemption amount.

Third, even though there is no estate tax in 2010, there is a tax rate given. This is not a typo but the maximum tax rate on gifts made over $1,000,000 that year.

In addition the above graduated rates must be taken in consideration with the marital exclusion when planning your estate. It would be simple to leave everything to your spouse (tax free of course) and then she can leave it to your children. However, that may end up in your estate paying “unnecessary” transfer taxes.

It sometimes helps to see an example of the above in action. Let’s take the case of a married couple with $4,000,000 in assets. Several years ago, when they did not have such a high net worth, the couple drafted wills which state that everything goes to the survivor and upon the death of the survivor their assets are given to their children.

Assuming the wife dies first in 2006, at her death, the husband will inherit or own the entire $4,000,000. He will pay no tax on this amount because of the marital exemption. When he dies years later, his children will inherit $4,000,000 and pay taxes on that amount. Assuming he dies in 2007, the taxes would be approximately $913,100 (this is assuming no liabilities or expenses).

Now let’s assume the same married couple went to an estate planning professional who suggested a “credit shelter trust” to minimize taxes.

Under each of their wills, on the first to die, the maximum unified credit will be placed in trust for the survivor. Assuming that she died in 2006, the first $2,000,000 is placed in this credit shelter trust. The wife’s estate files an estate tax return and declares to the government that $2,000,000 is given to her husband – tax free because of the marital exemption – and $2,000,000 is given to a separate entity, the trust. The estate uses her $2,000,000 exemption amount for this bequest to the trust and therefore owes zero in estate taxes.

The husband is the beneficiary of the trust. The income is paid to him and at the discretion of the trustee the principal can be used for the health, education, maintenance or support of the husband. At his death, the principal is paid to the children.

When he dies in 2007, in his name, he owns $2,000,000 (remember the other $2,000,000 isn’t owned by him but by the trust and the wife’s estate used her unified credit for this amount). He gives that $2,000,000 to his children tax free because he will use his exemption of $2,000,000 to offset that bequest. His children would also receive the $2,000,000 from the trust tax free because that was declared on the wife’s death and received the benefit of her exemption. Accordingly the children inherit $4,000,000 tax free.

That looks great except let’s now assume that the wife died in 2009 and the husband in 2011. When the wife died, the credit shelter trust is funded with $3,500,000 tax free. The husband only inherits in his name $500,000.

Any time he needs money to go on a vacation or fix his house, etc. he has to go to his trustee and ask for money. The trustee has to determine if it is for his health, education, maintenance and support and if it is in the best interests to distribute this amount. Even assuming that Trustee is liberal in distributing the money, many of our clients do not want to go “hat in hand” to their brother or cousin or whomever they have named as trustee to ask for money and to explain why they need it. Their rationale is that they worked hard, it’s their money and they shouldn’t have to explain their spending of it to anyone.

There are ways around this by using “disclaimer trusts” or maxing out the amount that can fund a credit shelter trust all of which should be discussed with you by your estate attorney.

Finally, I must end this article by saying that no one in the estate planning field believes the above will stay as law. The total exclusion and the sunset provision are not practical. But that is the law as it stands today. Therefore it is up to you to keep up with your estate plan. If the law changes, you must revisit your will. Even if the law doesn’t change, you should make sure that the practical result of the estate planning advice you were given makes sense.