The U.S. Federal Estate Tax is the tax levied on an individual’s estate on the transfer of his assets at his death. As a starting point, to understand how estate planning can be used to minimize estate taxes there are two concepts to be familiar with. The first concept is the Federal Estate Tax Exemption amount. The Federal Estate Tax Exemption amount is the amount of any estate that can be passed free of taxes. The current Federal Estate Tax Exemption amount is $5 million ($5.43 million, as indexed for inflation for individuals dying in 2015). Amounts above $5 million are taxed at a rate of 40%.
It’s helpful to envision the Federal Estate Tax Exemption as a coupon. In other words, imagine at death your estate must pay the Fed 40% of its value. However, each of us has a coupon that can be applied against the first $5 million of the estate that will pass tax free.
The second is the concept of the Unlimited Marital Deduction. Under the Unlimited Marital Deduction there is no estate tax due on assets transferred from a deceased spouse to his surviving spouse.
The issue in using the Unlimited Marital Deduction in conjunction with the Federal Estate Tax Coupon without additional planning is the likelihood of creating a tax issue at the death of the second spouse by failing to use a coupon at the death of the first spouse. Let’s give an example:
In our example we have a family of four: husband and wife Bob and Sara, and their two children Jake and Desiree. Bob and Sara’s combined net worth is $6 million, and for simplicity sake, we’ll say that each is worth $3 million. Bob passes away and leaves all of his estate to Sara. Because the transfer of Bob’s estate was to his spouse, the Unlimited Marital Deduction applied, and no federal estate tax was due.
A couple of years later, Sara passes away. She leaves everything to Jake and Desiree. Her estate is valued at $6 million. She has a $5 million coupon to apply, which means that $1 million of her estate is subject to federal estate taxes. At a rate of 40%, $400,000 of Jake and Desiree’s inheritance goes to the Federal Government.
Traditionally we could avoid this disinheritance through the use of trusts. At Bob’s death, his $3 million estate transfer into a trust. The trust is for the benefit of Sara during her lifetime, and then the assets transfer to Jake and Desiree at Sara’s death. The trust is set up in such a way that Sara can access the income produced as well as the principal of the trust for any reason to support her health and education as well as to maintain her lifestyle. Sara is named the Trustee of the trust.
Because Bob’s assets were transferred to a trust for Sara’s benefit as opposed to directly to Sara, the Unlimited Marital Deduction is not available to the estate. Rather, Bob’s estate uses his Federal Estate Tax Coupon.
On Sara’s death, since she was the beneficiary of the trust, and not the owner of the property left by Bob, the assets left in trust are not included in Sara’s estate for estate tax purposes. Sara’s estate totals $3 million. After applying her coupon, there is no estate tax due. So, Jake and Desiree receive their $6 million without giving any money to the government – $3 million from Sara’s estate, and $3 million from Bob’s trust.
If you recall our discussion on the Federal Estate Tax Exemption coupon, every estate has a coupon that may be applied so that up to $5 million of the estate may transfer free of taxes. This coupon is personal to the individual, and is lost if not used. For married couples, there is an Unlimited Marital Deduction, so that property transferred from a deceased spouse to the surviving spouse passes free of tax. However, this had the effect of potentially creating a tax burden on the surviving spouse’s estate if the surviving spouse’s original assets plus inherited assets were combined greater than the survivor’s coupon.
In 2010 legislation, congress introduced the concept of portability. With portability, the deceased spouse’s coupon is now portable, meaning that the deceased spouse can transfer his coupon, in whole or in part, to his surviving spouse. The idea of this legislation was to make things easier on the married couple so that they wouldn’t have to create trusts to avoid estate taxation.
So, Bob does not need to leave assets in trust in order to take advantage of his Federal Estate Tax coupon. He can leave everything to Sara and port over his unused coupon.
Another advantage to planning with portability has to do with favorable income tax treatment on the sale of inherited assets. This is the concept of double step up in basis. If you recall from our example of traditional estate planning for Bob and Sara, on Bob’s death his assets transferred in trust for Sara’s benefit. At his death, his assets received a step up in basis to their value as of Bob’s date of death. On Sara’s death, her assets also receive a step up in basis to their value as of Sara’s date of death. So, when Jake and Desiree received their inheritance, assets received from Sara had a cost basis as of Sara’s date of death, and assets received from Bob’s trust had a cost basis as of Bob’s date of death. Assuming Bob’s assets appreciated in value in the time between his death and Sara’s, when Jake and Desiree go to sell the assets inherited from Bob’s trust, they’re subject to a greater capital gains tax than if the assets were to have been owned by Sara.
With portability, Sara would have inherited Bob’s assets and received a step up in basis to Bob’s date of death, and since the assets are in Sara’s estate, at her death those assets would receive a second step-up in basis to Sara’s date of death. Thus the double step up in basis. Again, assuming the assets appreciated after Bob’s death, Jake and Desiree have a more favorable cost basis when they go to sell the assets.
By now, portability should sound pretty good – no need to employ trusts to avoid estate taxes, and better income tax treatment when the next generation inherits. There are of course some drawbacks. For one, trusts aren’t only good for estate tax planning. Most notably they can avoid the probate process in an estate settlement. Also, oftentimes trusts are needed to address a given family situation, as examples – where there is fear of divorce, or high probability of lawsuit, or in cases of blended families or families with minor children, just to name a few.
Also, in order to port one’s coupon to their surviving spouse, the estate must file an IRS Form 706, also known as a death tax return. Not only is this an additional expense, but one of the requirements of the 706 is to identify and value every asset owned by the deceased spouse. For some people, keeping the government out of their affairs is a primary goal that is defeated when planning with portability.
Brady Cobin Law Group PLLC Can Update Your Estate Plan
At Brady Cobin Law Group, PLLC, we would be happy to review your estate plan or create a new plan to meet your needs for the immediate and distant future. Contact us today to get started.