Estate Tax Basics

Should I worry about estate taxes? And 5 powerful techniques to reduce estate taxes.
Federal and state estate taxes are arguably the most onerous of all the taxes. The reasons are twofold; one, the tax rate are very high, and two, the average person has very little knowledge of estate taxes and therefore fails to implement tax planning techniques which can often avoid the imposition of estate taxes.

PLEASE NOTE: State and federal tax rates, exemption amounts, annual gift exclusions and the various rules and case law related to state and federal estate taxes are constantly changing. The discussion below is provided as a general overview of estate taxes current as of the time drafted and I strongly advise you to consult with a competent tax adviser to apply your unique situation to the most current state and federal rules and case law.

A. Do I need to worry about estate taxes?

In 2005, estates with total asset values below $1,500,000 pay no federal estate tax. The federal exemption amount is increased to $2,000,000 in 2006, increased again to $3,500,000 in 2009 and entirely eliminated for people dying in 2010. However, under the sunset provision of the Act, in 2011 the federal estate tax rates and exemption amount reverts back to the January 1, 2001 rules.

Oregon, on the other hand taxes estates that exceed $950,000 for 2005 and only increases the exemption amount to $1,000,000 for years thereafter. Therefore, you may be exempt from paying federal estate tax, but without proper planning, you may pay significant Oregon estate tax.

In addition, if you have given gifts to any person in excess of the annual gift exclusion (currently $11,000 but in most prior years was $10,000) in one year, your federal and state exemption amount may be reduced by the excess gift.

Therefore, if the total fair market value of all your assets (and your spouses if your married) less any debts you may have is greater than either the federal or the state estate tax exemption amount then you have a taxable estate. When adding up your estate make sure to include any life insurance on your life or your spouse's life, as the proceeds will most likely be included in your estate for tax purposes. You should also factor in any inheritances you are likely to receive before your death, future income and appreciation of your current estate.

Remember, for each dollar in your estate over the exemption amount, you may pay over 50% to the Internal Revenue Service and/or your state taxing authority. With modest planning, often costing less than $600, tax savings exceeding $250,000 can usually be achieved. How this is done is discussed below.

B. 5 powerful techniques to reduce estate taxes.

  1. 1. Utilize the federal and/or state exemption twice. The Internal Revenue Service allows every individual a single lifetime exemption amount which exempts that amount of their estate from federal estate taxation. If you are married both you and your spouse each have this exemption amount at your disposal. However, the exemption of the first spouse to die is often lost when the deceased spouse leaves their entire estate to the surviving spouse. This occurs because when the surviving spouse dies all of the assets of the entire marriage are included in the taxable estate but only one exemption amount is available.

    This costly consequence is avoided by having a will (or a living trust) which names a certain type of trust, not the spouse, as the beneficiary. This trust is known as an exemption trust (also known as a credit shelter trust) and, in most circumstances, as long as the first spouse does not leave more than the exemption amount to this trust no estate taxes will be due. Now when the second spouse dies this trust property will not be included in their estate and thus not taxed. In addition, the appreciation on the assets that are in the trust will also not be subject to estate tax on the second spouse's death. This could double your tax savings if the trust contains appreciating assets.

    Often clients worry that by leaving part or all of their estate to an exemption trust that the surviving spouse will not have control over those assets. This is simply not true. The surviving spouse is often the trustee of the trust and is allowed to distribute income and principal from the trust for their benefit.

  2. Remove life insurance proceeds from your estate. Like the examples above, life insurance is often a large portion of a person's estate. However, the average person is unaware that life insurance proceeds are usually includable in the insured's estate.

    To avoid estate taxes on life insurance the policy must not 1) name the estate as a beneficiary and 2) the deceased must not possess "incidents of ownership" at the time of death. In other words the deceased must not have had any of the following powers at the time of death: a) right to change beneficiaries; b) right to assign the policy; c) right to cancel the policy; or d) the right pledge or borrow against the policy.

    A life insurance trust is the most effective means of assuring that the proceeds of a life insurance policy are not included in your taxable estate and it is moderately simple to implement. The average costs of drafting and implementing a life insurance trust is around $950. When you compare the cost of the life insurance premiums and the fact that up to 55% of the insurance proceeds will be paid to the IRS and not to intended beneficiaries, it often makes economic sense to implement a life insurance trust.

  3. Give your estate away. This may sound like strange advice, but significant estate tax savings can be achieved by gifting. Basically, by gifting you reduce the value of your estate thereby reducing your estate taxes. Generally, any person may gift up to the annual gift exclusion ($11,000 in 2005) per year to any person without gift taxes. Amounts in excess of the annual gift exclusion may require the filing of a gift tax return. Married couples may combine their gift exclusion amount and thus gift twice the exclusion amount per year per recipient. The number of individuals who may receive an annual gift is unlimited.

    For obvious reasons, gifting is not appropriate for everyone. If you are relatively young and you intend on spending your kid's inheritance so to speak, then gifting is probably not for you. However, if you are relatively old and your expenses and lifestyle are well within your means, then gifting to the persons you already intend leaving your estate to may be an advisable technique to avoid estate taxes. In addition to saving taxes, you are able to observe first hand the benefit that a gift can make to a loved one.

    Despite the simple appearance of gifting, few other estate-planning techniques are more improperly applied by both professionals and individuals alike. Gifting at the wrong time, the wrong assets, failing to document, and numerous other mistakes can be very costly. When considering gifting I strongly advise that you consult with an experienced estate-planning attorney.

  4. Family limited partnership or family limited liability companies. Family limited partnerships and family limited liability companies can be particularly useful for the transfer of a family business to a child or children or the transfer of any large asset while utilizing the annual gift exclusion. It's effectiveness is derived from the ability to break apart an asset into Limited Partner shares or Limited Liability Ownership Units and combine with the ability to take "minority and/or marketability discounts" and keep the annual gifts of ownership below the annual gift exemption.

    For example, assume you own a business or piece of real estate valued at $1,000,000. A Family Limited Liability Company would be created and you would contribute the property in exchange for "membership units" of the Company. Assume you received 150 membership units for your contribution. At first glance you may assume that each unit is worth $6667 ($1,000,000 divided by 150). This may be true if you own all the units, but when you transfer 2 units to a child, that child now has a minority interest in the Company and in addition there is no real market for those units like there would be if they were publicly traded. As a result, you are allowed to apply discounts to that gift. Therefore those 2 units you gave away which appear to be worth $13,333 may actually be worth less than $11,000 and thus qualify for the annual gift exclusion.

    This technique can allow you to remove a substantial portion of your estate while continuing to maintain control of the underlying asset. Continued control is normally maintained by having the Family Limited Liability Company be controlled by a majority vote. So long as you own a majority you are able to control the underlying asset.

    You should understand that family limited partnerships and limited liability companies are advanced estate planning techniques, and the IRS rules and case law are constantly changing in this area, and therefore, only a qualified and experience estate tax practitioner should be consulted if you are considering this technique.

  5. Leave part of your estate to charity. Not only will a charitable bequest make you feel good while your alive, your estate will save taxes after your passing. Although, you should be aware that despite achieving tax savings of between 37 and 55 cents on the dollar, the corresponding 63 to 45 cents on the dollar will actually be coming out of your estate. This means that the beneficiaries other than the charity will receive less from your estate. Nevertheless, if you are charitably inclined, charitable bequests can be a wonderful way to support a needy charity and avoid the open hand of the IRS at the same time.