Understanding Federal Estate and Gift Tax

Death Tax

"A Sigh of Relief after Estate Tax Eliminated for Most."

For the last two years no one was certain what the estate and gift tax laws would be after 2012. In mid December of 2010 the President and the Congress agreed to a two year estate and gift tax law with the harsh, 2001 laws returning in 2013. Most experts thought the old law would return until Congress made changes later in the year. Surprisingly, except for an increase in the rate from 35% to 40%, the provisions of the 2010 law were made permanent by the "cliff" legislation passed on January 3rd of this year.

The highlights of the new law are the following:

  1. Amounts going to charity or to a surviving spouse are not taxed, and the amount that can pass to others without tax (the "exclusion") continued to be $5 million, adjusted for inflation (the adjusted amount for 2013 has not yet been announced by the IRS at the time this article was written).
  2. The federal gift tax exclusion continue to be $5 million, also adjusted for inflation.
  3. The estate and gift tax exclusions continue to be unified (that is, a "Taxable Gift" using part of the gift tax exclusion also uses the same amount of estate tax exclusion.)
  4. The rate for estate and gift tax is set at 40%.
  5. Portability continues to be available. Before 2010, if the estate tax exclusion was not used by an estate, it was lost. Now, any exclusion not used at the death of the first spouse can be added to the exclusion of the surviving spouse; that is a surviving spouse can have an exclusion which will protect assets worth $10 million plus the inflation adjustment.

There is now simplified estate planning for most clients. The $5 million exclusion and portability means that most of our clients don't need to be concerned about federal estate tax. If assets including insurance and retirement funds are less than $5 million, there should be no tax. For a couple, portability means that federal estate tax can be ignored if total assets are less than $10 million. Plans can be based upon what you want to do, not what you need to do to minimize tax. However, there remain concerns about your state's estate or inheritance tax and you will have to review your plan based on the federal estate tax in 2013.

State Estate Taxes - Virginia, like many other states, abolished its estate tax several years ago. If your state has no estate or inheritance tax, your estate planning must consider only the federal tax. Estate tax in Maryland and in the District of Columbia begins at $1 million, and Maryland also has an inheritance tax. Even though federal estate tax may be of little concern, any estate plan must take into consideration your state's estate and inheritance taxes.

Most estate plans done before 2008 need to be reviewed. Even though estate tax may be of little concern in the future, many existing estate plans should be reviewed and probably revised. The increase in the tax free amount to $5 million means that many plans not changed since the 1980's or 90's and plans prepared in the early 2000's will have unexpected results.

Married Couples. Most plans prepared before 2008 provide for a separate trust for each spouse and for division of assets between those two trusts. Before "portability," to avoid estate tax it was necessary at the first death to leave assets to someone other than the surviving spouse or to set up a "credit shelter" trust for the surviving spouse. If spouses left everything to one another, any exclusion not used after the first death was lost and only the credit of the survivor protected assets from estate tax at the second death. Now, the $5 million exclusion means that a plan which refers to the exclusion could result in the surviving spouse getting little while the credit shelter trust or children taking virtually all of the assets. Most older plans have a credit shelter trust which benefits the surviving spouse, but such a trust will result in unnecessary administrative burdens without any offsetting tax savings. Although there may be reasons other than tax reduction to put funds into trust for a spouse, such a trust, included in an estate plan only to minimize tax will result in the survivor having to deal with restrictions on access to funds and the requirement to file trust tax returns. These inconveniences made sense when they saved tax, but if there is no longer a tax reason for a credit shelter trust it will likely impose unnecessary administrative burdens and costs upon the survivor.

Individuals. Plans which based distributions on the estate tax exclusion may also have unintended consequences. Some plans provided that one or more charities were to receive any assets which exceed the maximum amount that can pass free of estate tax. The large increase in the exclusion may mean that charity will now receive nothing. That may or may not be what is intended.

The Gift tax lifetime exclusion is now $5 million, plus any inflation adjustment. That exclusion available to an individual is reduced by certain gifts. Generally, the exclusion is not reduced by "annual exclusion" gifts or by payment of certain medical or education expenses benefitting someone else. Annual exclusion gifts are gifts made in a calendar year of up to $13,000 which are made directly to or for the benefit of another individual. There is no limit on such gifts, so a person with six grandchildren may give $13,000 to each grandchild (a total of $78,000) every year without reducing the $5 million exclusion.

Gifts that reduce the $5 million gift tax exclusion include gifts to any individual during any calendar year which exceed $13,000, certain gifts to trust, and gifts in which the recipient has no present interest. These gifts are referred to as "taxable gifts." Making a taxable gift, however, does not automatically trigger a gift tax. Taxable gifts are reported each year on a gift tax return (IRS Form 709), and that return reports that year's gifts, the amount of the cumulative gifts, and the cumulative reduction in the gifts and estate tax exclusions. Only after total, lifetime taxable gifts are more than $5 million exclusion must gift tax be paid. The gift tax rate is now 40%.

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