Estate Planning 

• The Estate Tax Is Dead (Maybe)

• Estate and Gift Tax FAQ

• Tax Saving AB Trust

The Estate Tax Is Dead (Maybe)

After years of debate, Congress has passed legislation that will gradually repeal the estate tax over the next ten years.

In 2001, after ten years of debate, Congress passed legislation that will repeal the federal estate tax, a tax imposed on the assets left by the nation's wealthiest residents. The full repeal, however, won't take place for ten years -- and it's possible that Congress could revive the tax in some form before then. And in 2011, the whole tax bill will expire unless Congress votes to renew it. Meanwhile, though, estate tax rates will go down and exemptions will go up.

What's Next for Estate and Gift Tax

As of 2002, the estate tax affects only people who die leaving a taxable estate of more than a million dollars. (In 2001, estate tax was assessed on those who died leaving a taxable estate of more than $675,000.) The estate tax threshold will continue to rise until 2010, when it will be repealed. The top tax rate (currently 50%, on estates worth more than $3 million) will eventually drop to 45%. The exact dates and amounts of the changes are shown below.

Congress did not repeal the federal gift tax, although it raised the lifetime exemption and lowered the maximum tax rate. The lifetime gift tax exemption has gone up to $1 million and will stay there (unlike the estate tax exemption). That means you will be able to make a total of $1 million of taxable gifts over your lifetime before owing any federal gift tax. In addition, as of 2002 you can make an unlimited number of $11,000 gifts of cash or other property each year, completely tax-free. (Before 2002, you could give only $10,000 to an individual recipient in a calendar year.)

How the estate tax will fade away

If you're married, estate tax is most likely to be an issue when the second spouse dies. (When the first spouse dies, everything left to the survivor passes tax-free.) But if the second spouse owns all of the couple's property, and it's worth more than the estate tax exemption, estate tax will be due. So if you and your spouse together own more than $1 million (the current estate tax exemption), you may still want to think about using an AB trust, making gifts during life, or using another tax-avoidance strategy.

Other Tax Changes That Affect Estate Planning

This legislation affects all kinds of taxes, not just gift and estate taxes.

Generation-skipping tax. This is an extra federal tax on transfers made from older folks to someone in their grandchildren's generation; because there is already a $1 million exemption from the tax, it affects few people. When the estate tax is repealed in 2010, the generation-skipping tax will also disappear. Until 2010, the exemption amount will be the same as the estate tax exemption amount (shown in the table above).

Basis of inherited property. A change with far more widespread implications is the end of the "stepped-up basis" rule for inherited property. Under current law, when you inherit something, your tax basis (used to calculate taxable profit when you sell something) is the date-of-death market value of the property. So if the property's value has gone up significantly since the former owner acquired it, the basis is "stepped-up" to the date-of-death value. And that means you get a big tax break when you sell, because your taxable profit is based on the date-of-death value, not the lower basis of the former owner.

That rule will end when the estate tax does, in 2010. From then on, when you inherit property, you can choose to take a stepped-up basis for $1.3 million of it. If you inherit more than that, you’ll have to choose which assets get a stepped-up basis. For the rest, your basis will be the former owner’s basis or the date-of-death market value, whichever is smaller.

Small business exemption. Currently, some estates whose major asset is a family-run business or farm can qualify for a special $1.3 million estate tax exemption. That exemption will become superfluous when the basic individual estate tax exemption rises to $1.5 million, in 2004.

Source: www.nolo.com

Estate and Gift Tax FAQ

Most estates don't owe tax, but it pays to be informed. Here's a palatable introduction to estate and gift tax laws.

Will my estate have to pay taxes after I die?

It depends. The federal government imposes estate tax at your death only if your property is worth more than a certain amount, which depends on the year of death. But all property left to a spouse is exempt from the tax, as long as the spouse is a U.S. citizen. Estate tax is also not assessed on any property you leave to a tax-exempt charity.

Special rules apply to certain estates that contain family-owned businesses and farms, which may receive a special $1.3 million exclusion from estate tax. The rules for qualifying are complex; consult an estate planning specialist if you're interested. (This special exemption will become superfluous in 2004, when the individual exemption rises to $1.5 million.)

What are the rates for federal estate taxes?

The rates are steep, starting at 37%. The maximum is 55% for property worth over $3 million. The maximum rate is scheduled to decline gradually to 45% in 2009. There will be no estate tax in 2010, if the current tax law (passed in 2001) is not amended.

Are there ways to avoid federal estate taxes?

Yes, although there are fewer ways than many people think, or hope, there are. Here are some of the most popular:

• Tax-free gifts.You can give up to $11,000 per calendar year per recipient without paying gift tax. You can also pay someone's tuition or medical bills, or give to a charity, without paying gift tax on the amount. This reduces the size of your estate and the eventual estate tax bill.  (As of 2002 you can make an unlimited number of $11,000 gifts of cash or other property each year, completely tax-free.  Before 2002, you could give only $10,000 to an individual recipient in a calendar year.)
• An AB trust. Spouses leave their property in trust for their children, but give the surviving spouse the right to use it for life. This keeps the second spouse's taxable estate half the size it would be if the property were left entirely to the spouse.
• A "QTIP" trust, which enables couples to postpone estate taxes until the second spouse dies.
• Charitable trusts, which involve making a sizable gift to a tax-exempt charity.
• Life insurance trusts, which let you take the value of life insurance proceeds out of your estate.

Can't I just give all my property away before I die and avoid estate taxes?

No. The government long anticipated this one. If you give away more than $11,000 per year to any one person or non-charitable institution, you are assessed federal "gift tax," which applies at the same rate as the estate tax.

Making gifts of less than $11,000, however, can yield substantial estate tax savings if you keep at it for several years. Some other kinds of gifts are exempt from the gift/estate tax as well. You can give an unlimited amount of property to your spouse, unless your spouse is not a U.S. citizen, in which case you can give away up to $101,000 per year free of gift tax. Any property given to a tax-exempt charity avoids federal gift taxes. And money spent directly for someone's medical bills or school tuition is exempt as well.

Do some states impose death taxes?

A handful of states impose death taxes. These taxes are of two types: inheritance taxes and estate taxes.

Inheritance taxes are paid by the people who inherit your property, not your estate. Typically, how much they pay depends on their relationship to you. For example, Nebraska imposes a 15% tax if you leave $25,000 to a friend, but only 1% if you leave the money to your child. These rates vary from state to state.

State estate taxes are similar to the estate tax imposed by the federal government. Your estate must pay this tax no matter who your beneficiaries are. Every state except Ohio has abolished these taxes, at least in effect. The states just take part of any estate tax that you owe to the feds; it's a matter for accountants and tax preparers, but doesn't increase the tax bill. This may change, however, as the federal estate tax is phased out over the next few years; to make up the revenue shortfall, states may decide to impose their own death taxes.

Can I avoid paying state death taxes?

If your state imposes death taxes, there probably isn't much you can do. But if you live in two states -- winter here, summer there -- your inheritors may save on death taxes if you can make your legal residence in the state with lower, or no, death taxes.

You can find a listing of your state's death tax laws in Nolo's Plan Your Estate, by Denis Clifford and Cora Jordan.

Source:  www.nolo.com

Tax-Saving AB Trusts

Couples can save a bundle on estate taxes with this kind of trust.

First, the good news: Most people don't need to think about federal estate tax, which kicks in only when someone dies owning a very large amount of property. The amount of the estate tax exemption depends on the year of death.

If you (or you and your spouse) expect that your estate may owe the tax, consider creating a living trust that will both avoid probate and also save on federal estate tax. If you don't, there may be a big estate tax bill when the second spouse dies. That's because the survivor's estate includes his or her share of the couple's property plus the property inherited from the deceased spouse.

An AB trust lets a couple pass the maximum amount of property to their children or other beneficiaries after both spouses die, while at the same time ensuring the surviving spouse is financially comfortable. It's one of the few times in life you really can have it both ways.

Here's how it works. Instead of leaving property outright to the survivor, each spouse leaves most or all of his or her property to an AB trust. When one spouse dies, the surviving spouse can use that property, with certain restrictions, but doesn't own it outright. That's the reason behind the big tax savings: the property isn't subject to estate tax when the second spouse dies, because the second spouse never legally owned it.

When setting up an AB trust, each spouse names final beneficiaries who will receive the trust's property when the surviving spouse dies. Spouses often name the same people -- their children -- as final beneficiaries, but it's not mandatory.

Example: Christine and Terry have a combined estate of $1.5 million, all of which they own together. If each left his or her half, $750,000, to the surviving spouse outright, that spouse would be left with an estate of $1.5 million. If the surviving spouse died in 2003, $500,000 would be subject to estate tax.

But if Christine and Terry each leave their half of the trust property in a living trust with marital life estate, naming their five children as the trust's final beneficiaries, no estate taxes will be due. This is because when the first spouse dies in 2002, her $750,000 goes into the trust for the surviving spouse, and is subject to estate tax at that time. But because the amount in the trust is less than the federal estate tax exemption, no tax is due. Similarly, when the surviving spouse dies, his $750,000 is also less than the exempt amount.

The Surviving Spouse's Rights

The surviving spouse has limited power over the assets in the life estate trust. The extent of this power depends on the terms of the trust, within certain limits set by the IRS. If a surviving spouse is given more power than IRS rules allow, the surviving spouse becomes the legal owner of the trust property -- exactly what you don't want.

When the maximum powers are granted, the surviving spouse:

• receives all interest or other income from the trust property
• may use the property--for example, he or she can live in a house held in trust
• may spend the trust property in any amount for his or her health, education, support and maintenance, in his or her accustomed manner of living. (IRS Reg. 20.2041-1(c)(2).)

In other words, the surviving spouse has the right to use all of the trust principal for what really concerns most older couples: the surviving spouse's healthcare and other basic needs.

After the death of the surviving spouse, the marital life estate trust property is distributed to the final beneficiaries, chosen by the deceased spouse in the original trust document. The surviving spouse's property is also distributed to her beneficiaries.

Drawbacks of an AB Trust

Before creating an AB trust, couples should understand what they're getting into. Once one spouse dies, the trust cannot be changed.

Possible drawbacks include:

• Restrictions on the surviving spouse's use of the property. As discussed above, the surviving spouse has only limited rights to use trust property in the marital life estate trust.
• Expense of legal or accounting help. When one spouse dies, the survivor will probably need to hire a lawyer or accountant to determine how to best divide the couple's assets between the irrevocable marital life estate trust and the surviving spouse's revocable living trust. How the property is divided can have important tax consequences.
• Trust tax returns. The surviving spouse must get a taxpayer ID number for the marital life estate trust and file an annual trust income tax return. This isn't a big deal, but like any tax return, it requires some work.
• Recordkeeping. The surviving spouse must keep separate records for the marital life estate trust property.
• Uncertainty about the tax laws. Because Congress is almost sure to tinker with estate tax laws again in the next few years, you may end up wanting to change or revoke a trust you create now.

Given these disadvantages, it's obvious that not all married couples with a combined estate over the estate tax threshold should use a life estate trust. It's generally not advisable, at least not without the advice of an experienced estate planning lawyer, for many couples under 60. People in this age group don't want assets to be tied up in a trust if one spouse dies unexpectedly.

Commonly, younger couples create a basic probate-avoidance living trust. When they're older -- say in their later 50s or 60s -- they revoke it and create an AB trust. And if one spouse unexpectedly dies soon, the survivor will inherit everything free of estate tax, no matter what the amount. The surviving spouse will probably have years to use the money -- and to find other methods of reducing eventual estate tax.

Other couples who may not need an AB trust include:

• Couples where one spouse is considerably younger than the other. There's generally no need to burden the second spouse with a trust designed to save estate taxes when he or she is likely to live for many years.
• Many couples with children from prior marriages. There may be concern about conflicts between the surviving spouse and the deceased spouse's children, who must essentially share ownership of property for many years. 

Despite its possible drawbacks, a living trust with marital life estate does work very well for many families. Many older couples conclude that the relatively minor accounting and record keeping hassles are outweighed by the benefits.

Source:  www.nolo.com

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