How Do I Avoid Estate Taxes?
Clients often ask: What tax will I have to pay when I receive assets from an estate? Or What tax will my estate have to pay when I die? To adequately answer both of the questions I would need more than one column but I will attempt to offer a more cursory answer and explanation.
First, Minnesota and Wisconsin (the "States") have long abolished any inheritance tax. Neither the United States nor the States will ever enforce a tax upon residents as a result of such resident receiving a benefit or asset from a probate estate, trust, or other non-probate asset. However, both the United States and the States (the "Governments") levy an "Estate Tax."
An estate tax is levied against a decedent's estate. Accordingly, an estate tax is a tax that the estate must pay based on the gross value of a decedent estate regardless of how the assets are titled, i.e. in trust, in jointly. When calculating the size of a gross value of an estate for estate tax purposes the governments require the decedent to include the death benefit of any life insurance, any stocks, bonds, mutual funds, interest in a company, equity in home or other real estate, and any other asset in which the decedent maintained an interest. Basically, the family or beneficiaries of the decedent throw the total value of all assets transferring as a result of the decedent's death together, apply the applicable exemptions and deductions, and then calculate the tax.
A primary tool used by estate planning attorneys to reduce and avoid estate tax is to make use of the decedent's state and federal estate tax exemption. Each taxpayer is entitled to a state and federal estate tax exemption. The exemption amount varies depending on the taxpayer's state of residence. Practically, this means that any individual can pass an amount up to that parent's applicable exemption amount to his/her children or other beneficiaries tax free. An exemption is similar to a coupon that has an expiration date of that parent's death and if it is not used, it goes to waste. It is also important to note that any taxpayer can pass an unlimited amount of assets to his/her spouse without any estate tax.
Most married couples set up estate plan that transfers all assets to the surviving spouse upon the first spouse's death, and then at the surviving spouse's death all assets transfer to the children or other beneficiaries. For example, imagine that Marge and Homer are married and have three children, Bart, Lisa, and Maggie. Marge and Homer may set up a plan that at Marge's death transfers all of Marge's assets to Homer; then at Homer's death all couples assets would transfer to Bart, Lisa and Maggie. While this plan is simple and accomplishes many goals, by transferring all assets immediately to Homer at Marge's death, the plan fails to use Marge's exemption. As a result, Marge's exemption is lost and Homer can only use his exemption at his death resulting in every dollar over the exemption amount being taxed at the state and/or federal rate.
Today many estate planning attorneys recommend a "Disclaimer Will/Trust" which provides for the maximum flexibility and the ability to use both spouses' estate tax exemption while allowing the surviving spouse to access all of the assets. Practically, upon Marge's death all assets transfer to Homer, but Homer can then analyze the current exemption levels and his financial situation and elect to disclaim all, part, or none of those assets. If Homer elects to disclaim an asset, the asset is set aside and Homer may collect all income generated from the asset, and receive some distributions of principal, while the entire sum of the disclaimed asset is included in Marge's estate and uses Marge's exemption, effectively doubling the couple's estate tax exemption.
Accordingly, a properly drafted Disclaimer Will/Trust provides families the maximum flexibility and the opportunity to substantially reduce, and in some cases entirely avoid, estate taxes. This type of an estate plan is not for everyone, before selecting which type of estate plan is right for you it is imperative to review the state and federal estate tax exemptions and re-evaluate and value the size of your estate at your death, and if you are married, at your spouses death.