Estate planning is a sensitive subject because people do not wish to discuss the issue of death. However, if a person has assets valued over $2 million they will be subject to the highest possible estate taxes. Establishing and funding a trust is the most effective way to reduce these tax liabilities.
According to the Internal Revenue Code, estates that are valued over $2 million will be taxed at a rate starting at 37% and up to 50%. Items subject to taxation include the family home, secondary property, closely held businesses, life insurance, household furnishings, benefits under an employment plan, and other items that produce no lifetime income. In valuing the property, the IRS does not appraise the property at the time of purchase, but the fair market value at the time of the person’s death. The government will appraise the estate using the face value of insurance policies in the deceased’s name, including most group policies from work or other professional organizations.
Establishing a trust is an effective way to ensure your beneficiaries receive more of the estate proceeds than the government. The below sections discuss various methodologies estate holders use to minimize their taxable estates.
Reductions Using Irrevocable Gifts:
The most effective way of reducing taxes estate taxes is to set up an irrevocable trust and give away property during one’s life. This type of trust is recognized by the government as a separate taxable entity and pays on its accumulated income. Since gifts may not be changed, altered, or modified, asset placed within the trust are considered gifts to the beneficiaries.
Each year, an individual can make an unlimited number of $11,000 tax-free gifts of cash or other property. Couples may apply their annual exclusions valued at $22,000. These exclusions may be gifted to another couple for an exemption of $44,000 per year.
By gifting annually, the size of the estate can be greatly reduced. For example, if $10,000 is annually gifted to three of your children for ten years, the taxation on the estate is reduced by $300,000. In return, beneficiaries are less likely to see an estate tax burden beginning at least 37%.
So long as the spouse is a United States citizen, gifts to the spouse are tax exempt. If the spouse is not a United States citizen, the limit on tax-free gifts is limited to $100,000 per year. Direct payments of tuition and medical bills are also exempt from the gift tax.
Annual gifts larger than $11,000 per recipient are subject to the gift tax. For example, if Homer gifts $20,000 to Bart in 2006, $9,000 is subject to taxation. However, if two gifts of $10,000 are gifted in 2006 and 2007, both gifts are tax-free.
It is better to give away property that is likely to increase in value because the estate will be worth a lot more and estate taxes will be correspondingly higher. By gifting this property, not only does this property exclude present value, but it also eliminates future appreciation on the estate. For example, if Fred and Wilma gift stock valued at $100,000 to Pebbles and the stock doubles, $200,000 is eliminated from Fred and Wilma’s estate.
Unless the property will be given to a charity, it is not advisable to gift property that has undergone tremendous capital appreciation. If appreciated property is gifted to another person, the grantor’s tax basis is carried over to the recipient. Eventually, the recipient will pay higher taxes down the line. By contrast, if the property is inherited, the property is stepped up from what the grantor originally paid and the recipient will pay less in estate taxes. For example in 1986, Bruce paid $1,000,000 for Wayne Manner. Twenty years later, the property is now worth $5,000,000. If he gifts the property to Alfred, Alfred’s tax basis will be $1,000,000. Thereafter, should Alfred decide to sell the property, he will pay $4,000,000 in capital gains taxes. Alternatively, if Alfred receives the property through a devised will, the tax basis will be the market value at the time of Bruce’s death. If the property is still valued at $5,000,000, Alfred will have zero taxable gain.
Qualifying for the $11,000 annual gift exclusion to minors, two requisites must be met. First, documentation must specify that the child will receive the property by age 21. The trust must be irrevocable and the custodianship must end by the recipient’s 21st birthday. Second, according to section 2503Ã?Â© of the IRS code, if the recipient dies before age 21, the remaining property must go to the recipient’s estate or someone the recipient named.
Reductions Using an AB Trust:
Setting up an AB Trust is appropriate for couples who wish to maximize property gifts to beneficiaries after both spouses pass, while ensuring the surviving spouse is financially comfortable during their lifetime. Rather than conveying the estate to the spouse, the property is owned by the trust. The surviving spouse may use the property, even though it is not directly owned. The property is therefore not subject to estate taxation when the second spouse passes because it is not legally owned.
Prior to establishing this trust, couples need to also consider its drawbacks. The trust is irrevocable and cannot be changed once one of the spouses pass. Thereafter, the surviving spouse has limited rights to use the property. Furthermore, an attorney or accountant will need to be hired to determine how to divide the couple’s assets. Such consultation is needed to avoid certain tax consequences.
Reductions Using Charitable Trusts:
Establishing a charitable remainder trust is ideal for a grantor who has no beneficiaries and possesses charitable motives. The grantor receives an immediate and substantial tax deduction, while receiving the benefits of the property prior to their passing.
Although the trust is irrevocable, the grantor can continue receiving benefits because a fixed dollar amount or percentage of the trust’s value may be reserved. For example, the trust may be required to pay the estate $10,000 annually. Alternatively, the trust document can specify annual estate payments of 7% the trust’s value.
Besides removing the estate property which is subject to taxation, the grantor also receives an immediate federal income tax deduction. Furthermore, if appreciated property is sold and donated to the charitable trust, the grantor will avoid paying taxes on capital gains.
Supposes the grantor decided to later name a beneficiary, yet receive the same charitable benefits. A charitable lead trust may be established to discount the value of the gift, but keep the property for the intended beneficiaries.
Reductions Using Life Insurance Policies:
Another method of reducing estate taxes is setting up a life insurance policy in another person’s name or transferring the account within three years prior of the grantor death. So long as the policy is out of the estate holder’s name, annual contributions of $11,000 are considered tax free for the premium payments. For example, Scooby has set up a life insurance policy for his nephew Scruffy under Scooby’s name. This policy is worth $500,000. In addition, Scooby’s business partner has established another life insurance policy under Shaggy’s name. This policy is valued at $1,000,000. Since the second policy is listed under another name, when Scooby passes away only $500,000 is taxable to Scooby’s estate because he did not own the policy.
Alternatively, Scooby can establish an irrevocable life insurance trust. In doing so, the trust owns the policy rather than Scooby. Each year, Scooby purchases up to $11,000 in life insurance premiums. Ten years later, when Scooby passes away, the policy pays off $110,000. None of this money is taxable to the estate. Scrappy will then live off the income of the trust. When he passes away, his beneficiaries also take the remaining principal tax free.
Between the two options, Scooby must also consider ownership issues. If the policy is transferred, the grantor’s ownership is forever transferred. For example, if Scooby later decides to disown his nephew, the policy is non-cancelable or recoverable from Scrappy. If Scooby establishes an irrevocable trust, he cannot be a trustee. Furthermore, the trust must be established at least three years prior to Scooby’s passing to receive avoid the estate taxes.