GIFT and ESTATE TAX BASICS Understand How Gift And Estate Taxes Work to Fully Comprehend Why Tax Avoidance Strategies Are Commonly Employed In Estate Planning
ROBERT N. NASH ILLINOIS ESTATE PLANNING ATTORNEY
Although the primary goal of any estate plan is to provide a legal roadmap for the division of estate assets at the time of death, most estate plans attempt to achieve additional goals as well. One common goal of estate planning is tax avoidance. To understand why tax avoidance strategies are commonly employed in estate planning you need to understand how gift and estate taxes work first.
WHAT IS THE GIFT AND ESTATE TAX?
The gift and estate tax is a tax that is levied on your estate at the time of your death. All gifts made during your lifetime, as well as all assets owned by you at the time of death, are potentially subject to gift and estate taxes. The Internal Revenue Service, or IRS, considers anything you give away for which you do not receive full consideration in return to be a gift. In theory, this means that a $20 birthday gift you give a friend counts; however, because of the lifetime exemption and/or annual exclusion (discussed later) small gifts such as this do not actually incur gift and estate taxes. In addition, certain types of gifts, such as gifts to a political
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organization or gifts designated for the payment of medical or tuition are excluded. The value of gifts made during your lifetime added to the value of assets owned by you at the time of your death provides the figure on which gift and estate taxes are calculated. Historically, the gift and estate tax fluctuated every few years, reaching a rate as high as 55 percent in recent years. Recently, however, the American Taxpayer Relief Act of 2013, or ATRA, permanently set the gift and estate tax rate at a maximum of 40 percent. Although this rate is less than what it was just a few years ago, it still means that
The gift and estate tax is a tax that is levied on your estate at the time of your death. All gifts made during your lifetime, as well as all assets owned by you at the time of death, are potentially subject to gift and estate taxes.
you could lose a significant portion of the value of your estate to taxes without careful planning.
THE UNLIMITED MARITAL DEDUCTION The unlimited marital deduction allows a taxpayer to transfer assets of unlimited value to a spouse at the time of death without incurring gift and estate taxes. For illustration purposes, imagine that Thomas and Ellen are married at the time of Ellen’s death on January 1st, 2014. Ellen owned assets valued at $5 million
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when she died and made a total of $2 million worth of qualifying gifts during her lifetime. Ellen can leave all of the assets she owned at the time of her death to Thomas without Ellen’s estate having to worry about gift and estate taxes. Thomas’s estate, however, may pay the price (literally) down the road. What many taxpayers fail to think about when using the unlimited marital deduction is that it may overfund the surviving spouse’s estate. Let’s assume that Thomas also owns assets valued at $5 million when Ellen dies. Thomas now has an estate valued at $10 million which would incur gift and estate taxes were Thomas to die tomorrow.
THE LIFETIME EXEMPTION Each taxpayer is entitled to exempt a specific amount of gifts and assets over the course of a lifetime from gift and estate taxes. Just as the tax rate has fluctuated over the years, so has the lifetime exemption limit. ATRA also took any future guess work out of the lifetime exemption limit by setting it at $5 million, adjusted each year for inflation. For 2013, the limit is $5.25 million, set to be raised to $5.34 million for 2014. Assuming that Ellen left her $5 million estate to Thomas, he now has an estate valued at $10 million. If Thomas were to die in 2014 his estate could exempt $5.34 million with the remainder being subject to gift and estate taxes. In other words, Thomas’s estate would be taxed on $4.66 million ($10 million $5.34 million = $4.66 million). At a tax rate of 40 percent this means Thomas’s estate would lose $1,864,000 to taxes – a significant sum for any estate to lose.
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“PORTABILITY” All hope is not lost, however, for Thomas’s estate thanks to the concept of ―portability‖ which was introduced in recent years and made permanent in ATRA. Portability allows a married taxpayer to use any unused portion of his or her spouse’s lifetime exemption. For Thomas and Ellen, portability would allow Thomas to exempt another $3.34 million from his estate before gift and estate taxes became due. Thomas cannot use Ellen’s entire exemption because Ellen made lifetime gifts valued at $2 million, leaving $3.34 of her lifetime exemption available to be ―ported‖ over to Thomas. By adding Ellen’s unused exemption amount to Thomas’s exemption we get $8.68 million, Thomas’s total exemption amount. This brings Thomas’s taxable estate down to just $1.32 million ($10 million -$8.68 million = $1.32 million). That, in turn, brings the tax liability down from $1,864,000 to just $528,000, certainly a more favorable result but that still leaves Thomas and Ellen’s loved ones short over half a million dollars.
THE ANNUAL EXCLUSION With careful estate planning, Thomas and Ellen could have reduced their exposure to gift and estate taxes even more. While there are numerous tax avoidance strategies that can be incorporated into an overall estate plan, one of the simplest is
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utilizing the annual exclusion. The annual exclusion allows each taxpayer to make gifts valued at up to $14,000 (for 2013 and thereafter) to as many beneficiaries as the taxpayer wishes each year without incurring a gift tax. Married couples can combine their exclusions to gift assets valued at up to $28,000 each year. Moreover, gifts made as part of the annual exclusion are not counted toward the lifetime exemption limit. Let’s assume that Thomas lives another ten years after Ellen dies. Further assume that in each of those ten years Thomas makes gifts to each of the couple’s three children and five grandchildren valued at the yearly maximum of $14,000. Thomas could gift $112,000 per year for a total of $1.12 million tax-free prior to his death. Those gifts then reduce Thomas’s estate by $1.12 million as well without using any of his lifetime exemption, bringing his taxable estate down to just $200,000 ($10 million – exemptions of $8.68 million – exclusions of $1.12 million = $200,000). Thomas’s estate now owes just $80,000 in gift and estate taxes. By employing gift and estate tax avoidance strategies the amount of tax due on Thomas’s estate was reduced from $1,864,000 to $80,000, a savings of $1,784,000 – money that will go to Thomas and Ellen’s loved ones instead of to the IRS. Had Thomas and Ellen started earlier and worked with an estate planning attorney there is a good likelihood that they could have avoided a gift and estate tax obligation altogether.
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REFERENCES Forbes, IRS Raises Limit on Tax-Free Lifetime Gifts IRS, Frequently Asked Questions on Gift Taxes Forbes, After the Fiscal Cliff Deal: Estate And Gift Tax Explained IRS, What’s New—Estate and Gift Tax Wealth Counsel, Understanding the Impact in 2012 & 2013 of Federal Estate Tax Laws
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About the Author Robert N. Nash Robert N. Nash is a partner in the law firm of Nash Nash Bean & Ford, LLP. The law firm has offices in Geneseo and Moline, Illinois and conference facilities available throughout Northwestern Illinois. Mr. Nash chose the estate and business planning arena because he believes it provides a positive force in his clients’ lives. He practices preventative, rather than remedial law. Robert Nash focuses on all aspects of estate planning, including estate, gift and income taxes, trust and probate administration, real estate, and business. Nash Nash Bean & Ford, LLP www.nashbeanford.com Geneseo Moline 445 US Highway 6 East 5030 38th Avenue, Suite 2 Geneseo, IL 61254 Moline, IL 61265 Phone: Phone: (309) 762-9368 Gift and Estate Tax Basics(309) 944-2188 www.nashbeanford.com Fax: (309) 944-3960 Fax: (309) 944-3960
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