Estate Taxes FAQS
Q: Will my estate be subject to death taxes?
There are two types of death taxes that you should plan for: the federal estate tax and state estate tax. The federal estate tax is calculated as a percentage of your net taxable estate, which itself consists of all assets under your ownership or control after subtracting certain deductions. These deductions can range from charitable contributions to administrative costs (including funeral and burial expenses). Currently, the federal estate tax applies to estates with net assets of $5,250,000 or more.
Even if you believe that the federal tax won’t apply your estate, it is still necessary to determine whether state estate and inheritance taxes will. It’s also possible that your estate may be taxable in the future as your assets appreciate in value. For these reasons, going over your estate plan with an estate planning attorney on a regular basis is an important part of your future planning. Doing so will also ensure your estate plan makes adjustments for alterations in tax laws as well as changes in your individual circumstances.
Q: What is my taxable estate?
Your taxable estate consists of the total value of the assets you own, minus liabilities and deductions.
Your assets include:
- Your home or any other real estate belonging to you
- Your business or any business interests
- Your bank accounts, including your share of any joint accounts
- The full value of your retirement accounts
- Any life insurance policies belonging to you
And examples of the liabilities and deductions you would subtract from your assets are:
- Funeral expenses paid for by the estate
- Debts you owe at the time of death
- Bequests to charitable organizations
- The value of the assets inherited by your spouse (as long as he or she is a U.S. citizen)
Any taxes assessed on the taxable part of the estate are paid from the estate itself before the assets are distributed to your beneficiaries.
Q: What is the unlimited marital deduction?
As a married individual, you are allowed by the federal government to give an unlimited amount of assets to your spouse, tax free, so long as they are transferred by gift or bequest. This unlimited marital deduction has the effect of delaying the payment of estate taxes: upon the death of the first spouse, all assets may pass to the surviving spouse. Then, at the passing of the surviving spouse, all remaining assets in the first spouse’s estate over the applicable exclusion amount ($5,250,000 in 2013) will be included in the survivor’s taxable estate. Application of the Unlimited Marital Deduction is limited, however, to surviving spouses who are United States citizens.
Q: What is a Credit Shelter or A/B Trust and how does it work?
A Credit Shelter Trust (sometimes known as a Bypass or A/B Trust) can be used to avoid or decrease federal estate taxes. It is most often used by a married couple when the value of their estate surpasses the federal estate tax exemption.
Thanks to the Unlimited Marital Deduction, the federal government allows a married person to gift or bequeath an unlimited amount of assets to his or her spouse, tax free, and leave any of his or her estate tax exemption untouched. For individuals with substantial assets, however, the Unlimited Marital Deduction only succeeds in delaying estate taxes, rather than eliminating them. This occurs because, when the second spouse passes away with an estate valued at more than the federal exemption total, the amount of the estate exceeding the exemption may be subject to estate tax. By that time, of course, the first spouse’s estate tax credit was never taken advantage of and now cannot be used. It is possible to avoid this situation by establishing a Credit Shelter Trust, which works to preserve both of the spouse’s exemptions. Upon the first spouse’s passing, two things should happen: (1) even if no taxes are due, an estate tax return is filed, and (2) the Credit Shelter Trust creates a separate, irrevocable trust comprised of the decedent’s assets, but funded only to the extent of his or her exemption. The rest of the estate is then bequeathed to the surviving spouse. As a result, the irrevocable trust makes full use of the first spouse’s estate tax credit and the assets in the trust are not taxed, even if they appreciate in value. In a Credit Shelter Trust, the surviving spouse is the beneficiary and any children are beneficiaries of the remaining interest.
Q: What is a Qualified Personal Residence Trust (QPRT) and how does it work?
Our homes frequently hold great value for us, both sentimental and material; as they are often among the largest parts of our estate, they can also hold great value to federal and state tax agencies. One way to reduce the tax burden generated by a home is to establish a Qualified Personal Residence Trust or QPRT (pronounced “cue-pert”). With this type of trust, you can still live in your home or vacation house, but transfer ownership for a substantial discount and freeze its value when it comes to estate taxes. It works like this: You grant the title to your house to the QPRT (often to benefit your family members), but specify that you can continue to live in the house for a certain length of time, usually years. After that period has passed, the property passes to your beneficiaries without any additional estate or gift taxes, despite any appreciation in value the house may have accrued. Once that happens, you are allowed to continue living in the home but must pay rent to your family or beneficiary so that the property is not included in your estate. This can be advantageous, serving to further decrease the value of your taxable estate, although the rent income will be taxable as income for your family. On the other hand, should you die before the end of the period, inclusion of the total value of the house in your estate is unavoidable, but in the majority of cases you are no worse off than you would have been had you not established a QPRT. A QPRT also provides great protection from creditors: once the QPRT is created and your residence is transferred to it, the property is technically owned by the trust, rather than you.
Q: What is an Irrevocable Life Insurance Trust and how does it work?
It is commonly understood that the proceeds of a life insurance policy paid to your beneficiaries are not subject to income taxes. Unfortunately, this does not hold true for Federal Estate Taxes. In fact, since life a insurance pay-out is considered part of your taxable estate, your family or beneficiaries could stand to lose up to half of its value to estate taxes. This is where an Irrevocable Life Insurance Trust can help. The goal of an ILIT is to own your life insurance policy, keep the policy outside of your estate, and prevent the proceeds from being taxable as part of the estate. There are a number of ways to set up an ILIT. As one option, ILITs can be built to provide income to a surviving spouse while granting the rest to your children from a previous marriage. And in the case of a child who is not financially responsible, you can arrange for distribution of a restricted amount of the insurance proceeds over a given length of time.
Q: What is a Family Limited Partnership and how does it work?
A Family Limited Partnership (FLP) is a type of limited partnership formed among members of a family. A limited partnership has two kinds of partners: (1) general partners, who manage the trust, and (2) limited partners, who are passive investors. While general partners hold unlimited personal liability for partnership responsibilities, limited partners bear no liability aside from their capital contributions. This kind of partnership is often established by older generation family members who contribute assets to the FLP and receive both a small general partnership interest and a large limited partnership interest in return. These family members then transfer the limited partnership interests to their children and/or grandchildren, but retain the general partnership interests that allow for control of the partnership.
The FLP has several benefits. First, by transferring limited partnership interests to family members, older family members can reduce the amount of their estate subject to taxation, while also continuing to direct decisions about the partnership’s assets and any distributions. Furthermore, because the limited partners are not responsible for the partnership’s operations, a minority discount can be applied to their interests to reduce their value for purposes of gift and estate taxes. Finally, a well-constructed FLP may provide protection from creditors, since the general partners are not required to distribute the partnership’s earnings.