Upon your death, the value of everything you own (your money and property, including life insurance), reduced by amounts you owe (mortgages, credit cards, income taxes etc.) is known as your estate and may be subject to federal (and possibly state) estate tax. During your lifetime, it is commonly referred to as your net worth.
One of the major provisions of The American Taxpayer Relief Act of 2012 (ATRA), which was enacted on January 1, 2013, was to make the estate tax a permanent part of the Internal Revenue Code. If your estate is taxable (defined later), there are several things you can do during your lifetime to mitigate the estate tax consequences.
ATRA set the top federal estate tax rate at 40% (up from 35% prior to ATRA) and raised the exemption amount of an estate (the portion not subject to taxation) to $5 million, indexed annually for inflation. For 2016, the estate and gift tax exemption has been set at $5.45 million, up from $5.43 million in 2015. If the value of your estate exceeds the exemption amount, you have a taxable estate, the excess of which is subject to the 40% tax rate.
If you expect to have a taxable estate, the combined federal and state tax consequences could easily exceed 50%. For example, Washington has the highest state rate at 20% ($2.054 million exemption), followed by several states such as New York and New Jersey at 16% ($4.188 million NY exemption, $675K NJ exemption); Connecticut and Maine (12% and $2.0 million) have the lowest. Furthermore, in New York you lose the entire exemption amount if the value of your estate exceeds it by 5%. That means if your estate exceeds about $4.4 million, your entire New York estate would be subject to the 16% rate; not just the excess over the exemption amount.
Now unless you want your estate to personally finance the federal government as well as your resident state municipality (and, in some cases a nonresident state in which you own property), you may want to consider a few techniques to mitigate the estate tax hit:
- Maximize the power of your annual gift exclusion
Most people know that they can make unlimited annual gifts to each of their family members, friends and others of up to $14,000 (also adjusted annually for inflation) per recipient without incurring gift tax or filing a gift tax return. What may be less common knowledge, however, is that gifts exceeding that amount can still escape taxability by filing a gift tax return and utilizing the unified credit; named as such since the federal gift tax and estate tax are integrated into one unified tax system. In other words, the estate exemption amount can be used during your lifetime through gifting.
If you exceed the annual gift tax exclusion amount in any year, you have the option of either paying the tax on the excess or utilizing the unified credit to avoid paying the tax. Essentially, your heirs can “inherit” now as a gift or inherit later upon your death at the price of lowering your estate and gift exemption (the unified credit) by the amount that exceeds the annual exclusion. The benefit of making lifetime gifts is that it reduces your potential taxable estate over time at their current value, thereby removing from your estate any value growth during the remainder of your life.
By using the unified credit during your life, the amount available to offset the value of your estate (your exemption amount) upon your death will be reduced. On the other hand, if you pay the gift tax, the taxed gifts are added back to your estate, the estate tax is recalculated and the gift taxes you previously paid are credited against any estate tax due. Two things should be noted – one, the donor, or giver is responsible for any gift tax due, not the recipient; and two, if you do not anticipate having a taxable estate, it simply doesn’t matter whether you make any gifts during your lifetime; just don’t pay any gift taxes.
In addition to the annual exclusion amounts, the following gifts will not trigger the gift tax:
- Charitable gifts
- Gifts to a spouse
- Gifts to a political organization for its use
- Gifts of tuition are unlimited as long as direct payment is made to the educational institution (Books, supplies and living expenses do not qualify)
- Gifts of medical expenses are also unlimited, as long as they are paid directly to the medical facility
- If married, elect the portability option
This allows the surviving spouse to add to his or her exemption any unused exemption left by the first spouse to die. This effectively makes the 2016 exemption $10.9 million for a married couple, but it is not automatic. While an unlimited marital deduction allows you to leave all or part of your assets to your surviving spouse free of federal estate tax, you want to be able to offset the maximum exclusion amount on the second to die’s death. To do so, the portability option must be elected when the estate tax return of the first spouse to die is filed, even if no federal estate tax is owed.
- Remove life insurance proceeds from your estate
The average person is unaware that life insurance proceeds are includible in their estate, often comprising a significant portion of it, thereby making the estate taxable. There is a way, however, to avoid estate taxes on life insurance. To do so, the policy must not
- Name the estate as a beneficiary
- Give the deceased what is referred to as “incidents of ownership” at the time of death. To achieve this, the deceased must not have had any of the following powers or rights at the time of death
- To change beneficiaries
- To assign the policy
- To cancel the policy; or
- To 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, is moderately simple to implement and its cost is modest. After all, most would agree that the federal and state governments are not their intended primary beneficiaries who stand to “inherit” more than half of the insurance proceeds if it is determined that the deceased had incidents of ownership.
- Leave part of your estate to charity
Not only will a charitable bequest invigorate your philanthropic spirit, it will help to shrink your taxable estate. Bear in mind, however, that despite the tax savings, the full amount of the bequest will not pass to your heirs. So while you may have saved upwards of 60% in estate taxes, the other 40%, as well as the portion saved in taxes will all go to the charitable organization of your choice. Nevertheless, charitable bequests can be a wonderful way to support a needy charity while slapping the open hand of Uncle Sam.
- Set up a family limited partnership (FLP) or limited liability company (FLLC)
These can be very useful for business succession planning or for the transfer of any large asset while utilizing the annual gift exclusion. Essentially an asset is contributed into a newly formed FLP or FLLC where it is divided into shares or units that by themselves have no ready market and are therefore valued at a “minority and/or marketability discount”. The shares/units of ownership are then gifted on an annual basis at a discounted value that does not exceed the annual gift exclusion.
For example, assume you own a business (or real estate) valued at $2,000,000. A FLLC is formed to which the asset is contributed in exchange for 200 membership units of the FLLC that are typically divided into general and limited partner/member interests. The elder owner/founder maintains control by retaining the general partner/member shares that grant voting rights and decision making ability. The limited partner interests (with no such rights) are gifted to younger family members on an annual basis. Implicitly, it appears that each unit is worth $10,000 ($2M divided by 200). This may be true if you were to own all 200 units, but when you gift 2 limited units to each of your three sons, they now have only a minority interest in the FLLC for which there is no real market (as there would be if the units were publicly traded – think stock exchange). To account for the minority interest, discounts are applied to that gift. Assuming that a 30% minority discount is deemed to be reasonable, the actual discounted value of each set of 2 gifted units is $14,000 (2 X $10K X 70%) – the amount of the annual gift exclusion.
At a time when many small businesses need to be sold, leveraged or liquidated just to pay the estate taxes, this technique allows you to remove a substantial asset from your estate over time while continuing to maintain control of the underlying asset that you intend to pass to the next generation. Continued control is normally maintained by a majority vote or general partner/member interest. IRS rules and case law are constantly changing in this area. Please consult your estate tax attorney and accountant if you are considering this technique.
If you have questions, please contact Victor C. Belgiorno at 516-861-3704 or .