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Avoiding Estate Taxes - Updated May, 2011

What is the status of the Federal Estate Tax?

President Obama signed into law on December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act.  The law is technically only valid for two years, and on December 31, 2012, it will “sunset” – meaning that absent a new law, the federal estate tax exemption and rate will revert to the 2002 figures.

What is Estate Tax “Portability?”

“Portability” of federal estate tax exemption is a term that applies to married couples. If the first spouse dies without using all of his or her estate tax exemption, then the unused portion will be shifted to the surviving spouse's exemption, so that he or she can use it in addition to his or her own.  For high-worth couples, this makes a big difference.

Why is Estate Tax Portability Important to High-Worth Couples?

Assume a married couple owns jointly titled assets with a net worth of $6,000,000. 

Absent portability, when the Husband dies there is no need to use his exemption, because all of the couple’s assets are titled jointly.  The deceased Husband may transfer his share of these assets to the Wife, and the estate will not incur additional federal estate taxes.  This is because of the unlimited marital deduction. 

Later, the Wife passes away, and the exemption amount is still at the current $5 million level, and the estate tax rate is 35%, as it is now.  The estate itself is still worth $6,000,000.

The Husband’s exemption would be gone (absent portability), and so when the Wife passes, she may only use her own individual exemption amount of $5,000,000.  The estate would thus be left with a tax bill of $350,000 once she passes away.  

To summarize, a $6,000,000 estate is reduced to a $1,000,000 taxable estate after an individual’s exemption of $5,000,000.  The $1,000,000 estate, taxed at the 35% estate tax rate, would lead to a taxable amount of $350,000 at the Wife’s death.

With Portability, the following would result instead:

Since the Husband did not use his $5,000,000 estate tax exemption, the Wife’s exemption will be increased by this unused amount.  Effectively, the Wife’s estate would enjoy a $10,000,000 exemption, and the estate worth $6,000,000 at her death would owe no estate taxes.

How should Executors of decedents who passed in 2010 approach the Estate Tax?

On December 17, 2010, President Barack Obama signed important tax relief laws.

Section 301 reinstates the estate tax.

Executors of decedents who passed in 2010 may either file Form 706 or apply the 2010 laws, or in the alternative, they may choose to use the new $5 million exclusion and the 35% estate tax rate. 

Are there any special considerations for decedents who may have passed away in early 2010?

Since the required due date for decedents who passed in early 2010 has expired, the required due date for the tax return or payment of such taxes will be nine months after the date of enactment.  The filing date for the Generation Skipping Transfer Tax (GSTT) returns will also be nine months after enactment (October 17, 2011).

Federal tax law allows an unlimited transfer of property to a surviving spouse without imposing any estate tax. This is a result of the "unlimited marital deduction." In addition to the unlimited marital deduction, Federal tax law allows every individual to transfer a specific amount tax-free at death to a beneficiary or beneficiaries other than a spouse. This amount, called the "exemption equivalent amount," was $3,500,000 in 2009.  2010 was an odd year, in that there was no Estate Tax.  This year, in 2011, the exemption is $5,000,000 for an individual or $10,000,000 for a married couple. 

If you are married and you leave everything to your spouse upon your death, your estate will not have to pay any estate taxes due to the effect of the unlimited marital deduction. However, upon the death of your spouse, all amounts in excess of the unified credit amount will be subject to the Estate Tax.

One way to minimize this tax problem is to establish an estate plan so that upon the death of the first spouse a “Family Trust” (also called a "Credit Shelter Trust" or "ByPass Trust" or “B Trust”) is created. Typically, the purpose of the Family Trust is to provide support for the surviving spouse during his or her lifetime, with the remainder of the trust then going to the children upon the death of the surviving spouse.

Flexible Planning Using a Disclaimer-Funded Family Trust

Given the state of flux and current uncertainty of the future estate tax laws, many married couples desire to preserve post-death flexibility as to whether to establish a Family Trust upon the death of the first spouse. To allow this flexibility, many couples will establish estate plans leaving everything outright to the surviving spouse, but providing a Disclaimer-Funded Family Trust in the event that the surviving spouse chooses to file a disclaimer. The idea is that the surviving spouse will meet with the estate planning attorney after the death of the first spouse to decide whether to disclaim and, if so, how much to disclaim. In making this decision, the surviving spouse would consider the amount of the assets, the status of the estate tax laws at that time, and his or her own economic needs.  A sufficient amount could be disclaimed to fully fund the Family Trust of the first spouse to die or to partially fund the Family Trust. Partial funding of the Family Trust might be preferred because the amount not disclaimed, which will still be owned outright by the surviving spouse, may be less than the applicable exclusion amount available to that surviving spouse.

Disadvantages of Using a Disclaimer-Funded Family Trust

The reliance on a disclaimer-funded family trust can be problematic for several reasons. One potential problem is that after the death of the first spouse, the surviving spouse might change his or her mind and be unwilling to disclaim even though disclaimer is advisable for tax and estate planning purposes. Second, because the decision to disclaim must be made within 9 months after the first spouse's demise and before the surviving spouse accepts any benefits from the assets to be disclaimed, the surviving spouse might inadvertently accept benefits before disclaiming, thereby frustrating the attempt to disclaim.

If you are interested in an estate plan using a Family Trust, more details can be discussed at your first appointment.

For Additional Information:

What is Probate?
Why Most People Want to Avoid Probate
What is a Revocable Living Trust?

How Does a Revocable Trust Avoid Probate?
What About Irrevocable Living Trusts?
Choosing a Trustee

Estate Planning Glossary