Understanding the Estate and Gift Tax
There are two types of federal taxes. The first, and more well-known one, is called income tax.
The second type of tax is known as transfer taxes. There are three kinds of transfer taxes: the gift tax, the generation-skipping transfer tax, and the federal estate tax.
One of the primary goals of estate planning, in addition to avoiding state probate court, is to eliminate or reduce the amount of federal transfer taxes and income taxes that your family will pay.
This article will discuss transfer taxes generally and, more specifically, the federal estate and gift tax.
Transfer taxes are eponymous: if you transfer something to someone or to an entity, the IRS seeks to tax the transfer.
If I add my daughter’s name to the home deed, that’s a transfer. It is subject to gift tax. If I give you money, it’s subject to gift tax. If I transfer shares of my company to you, that’s also subject to gift tax.
If I give property to my grandson, that’s a transfer as well and because the transfer skipped a generation, it is subject to a transfer tax called the generation-skipping transfer tax.
Finally, when I die, there will be a transfer of my assets to other people. This type of transfer tax is called the federal estate tax.
As you can see, there are many types of transfer taxes that we need to be mindful of everytime assets change hands. The Internal Revenue Code lists out all kinds of complex rules that govern what types of transfers are taxed and what are the exceptions.
Specifically, the federal estate tax is discussed in IRC §§ 2033-2043.
Your Taxable Estate
To understand the federal estate tax, you first need to know what is meant by your “gross estate.” This is everything that you own at the time of your death — from your socks to your stocks! When you die, whatever comprises your worldwide assets is subject to estate taxes. In other words, they look at everything you own around the world, and all of that goes into a bucket called your “gross estate.”
The gross estate includes your property, bank accounts, stocks, bonds, CDs, retirement accounts, life insurance policies, businesses, and even personal property such as household furnishings and jewelry. Even assets not owned directly in your name — such as assets owned in your living trust, or assets you co-own with another person, or life insurance policies that you own but that will pay out to you children at death — will also be included in your gross estate.
At your death, the total value of your gross estate is added up and then reduced by any debts and mortgages you may have, along with certain other deductions. This net amount – called your taxable estate – is then compared to something called your lifetime exemption (also called your “applicable exclusion amount” or “applicable credit amount”). I will refer to this as your “coupon.” The coupon refers to how much money you can transfer tax-free in your life or at death. I’ll say more about this later.
If your taxable estate at death is less than your coupon, there is no estate tax due. But if your taxable estate at death is greater than your coupon, then there is an estate tax owed on the difference, and this estate tax must be paid by your estate 9 months from your date of death. Thus, the estate tax depends on 3 things: (1) the year you die; (2) what the coupon amount will be in the year that you die; and (3) the value of your taxable estate in the year that you die.
There are a few important rules to know about how your coupon works:
1. Value based on Residency
First of all, the value of your coupon is based on whether you are a US resident. The test for residency is based on a concept known as “domicile.” This is a subjective test that is based on an individual’s intent to remain permanently in the U.S. (This is a different test from determining U.S. income tax residency). If a non-citizen intends to reside in the United States at death, then the individual is considered a US resident for estate tax purposes. If a non-citizen does not intend at death to reside in the US, then that person is not considered a US resident.
How is intent determined? The test for residency for transfer tax purposes takes into account the following non-exhaustive factors:
- Statement of intent (in visa applications, tax returns, will, etc.)
- Length of US residence
- Green card status
- Style of living in the US and abroad
- Ties to former country
- Country of citizenship
- Location of business interests
- Places where club and church affiliations, voting registration, and driver licenses are maintained
If an individual is a US resident, the coupon is worth $10 million (plus inflation). Taking inflation into account, in 2020, the coupon is worth $11.58 million per US resident and in 2021, it is worth $11.7 million. Again, this means that if an individual has not used their coupon during their lifetime, then they can transfer up to this amount tax-free at death.
But, if an individual is not found to be a US resident, the coupon is worth only $60,000.
2. Annual exemption constantly changes
The coupon value changes every year and only becomes relevant in the year of your death. For example, if an individual dies in 2020 and has not made any taxable lifetime gifts, the amount he can transfer tax-free is $11.58 million. If that individual died in 2011, the amount he could transfer tax-free was only $5 million (assuming no taxable lifetime gifts were made).
Thus, whether there is an estate tax or not depends in large part on the year you die and what the coupon value is worth in the year you die. The coupon value changes in large part based on which party is in office. Historically, Republicans are in favor of either eliminating the estate tax altogether or, alternatively, maintaining very high coupon amounts. Democrats generally prefer to keep the estate tax and maintain lower coupon amounts. The percentage rate of the estate tax also can vary (currently, it’s 40% but it has been as high as 55%).
Given the likelihood of flux, it’s important to keep your eyes on the estate tax exemptions. I liken the process to shooting at a moving target.
3. The federal gift tax
The full value of the coupon may not be available at death if you made gifts during your lifetime.
In 2020, a US resident (donor) can make a tax-free gift of $15,000 to any individual (donee) without reporting the gift to the IRS. You can make an infinite number of gifts up to the limit each year. For example, Bill Gates legally can gift $15,000 to each person in America tax-free and without disclosure to the IRS (although in his case, he will likely let them know!). Neither the donor nor the donee pays any taxes on the transfer. However, if he makes a gift of $115,000 to you in 2020, the first $15,000 is tax-free, the balance is not. Thus, the extra $100,000 he gifted will be “taxed” to him — not to you. If gifts are taxed, they are taxed to the donor, not the donee, generally.
Will Bill Gates pay money on this $100,000 amount? Not exactly. The way it works is that any gifts made over and above the annual gift tax exemption reduces the donor’s lifetime coupon. For example, using our hypothetical, the taxable portion of the gift ($100,000) reduces the lifetime coupon value from $11.58 million to $11.48 million, which means that if the individual dies in 2020, he can now only leave to his heirs $11.48 million tax-free instead of $11.58 million because he has already gifted $100,000 in life.
To use another example, if an individual in 2011 made $5 million of taxable gifts (for example, a parent who decides to make a gift to their children while alive), and then the parent died in 2011, he would have no more coupon value remaining and, thus, any amounts he left at death in 2011 would be taxed at death. But if the individual used up $5 million in taxable gifts in 2011 and then died in 2020, he could still leave tax-free at his death $6.58 million because the coupon value was higher in the year of his death ($11.58 million, the value of his coupon at death in 2020, less the amount of lifetime taxable gifts made in 2011, $5 million).
4. Unlimited marital deduction
What happens in the situation of a married couple? Let’s say Bill Gates passes away and leaves everything to Melinda Gates. Because both Bill and Melinda are US citizens, they have a special coupon called an “unlimited marital deduction.” This “super-coupon” allows for an unlimited amount to be transferred between husband and wife both during life and at death. So if Bill passes away, all his billions of dollars can transfer to Melinda tax-free and it’s not an estate tax because of the super-coupon. Similarly, if Bill decided during his lifetime to gift everything from his name to his wife’s name (and transfer billions of dollars to her), there would be no gift tax because of the super-coupon.
Thus, if your spouse is a US citizen, you can transfer to your spouse an unlimited amount of money during life or at death without worrying about the gift tax or estate tax. (If you or your spouse are not U.S. citizens, you may need to utilize a special trust called a QDOT).
5. Portability at Death
In 2012, the federal and gift tax rules were rewritten to include a very important provision known as portability, which applies to married individuals. Portability permits that a married couple can effectively combine their coupons when they both die.
For example, Husband and Wife (H and W) are US residents and own $10 million of assets. They make no lifetime taxable gifts. The H dies in 2020, when the estate tax exemption is $11.58 million. W’s estate planning lawyer timely files IRS Form 706 at H’s death and elects portability. This means that W is applying for H’s unused $11.58 million coupon. If W does not apply for this, she loses the ability to use this coupon.
Now, W dies in 2035. Let’s assume by this point, the assets are worth $15 million. Let’s also assume that W’s coupon value in 2035 is only worth $1 million.
How much can W leave to the children tax-free?
The answer is that W’s coupon in 2035 ($1 million) is added to H’s coupon in 2020 ($11.58 million) and so the total that can be left tax-free in 2035 is $12.58 million. However, if W’s lawyer did not file the Form 706 and elect portability when H died in 2020, W can now only leave to the children $1 million tax-free.
I have heard many accountants, financial advisors, and even lawyers say to their clients when H dies, “You don’t need to file the 706 because you don’t owe any estate taxes!” True, but those advisors are not seeing the bigger picture! By not filing the 706 and electing portability, they have closed the door in the future of ever being able to use H’s coupon. It’s like saying “no” to free money!
Compared to Inheritance Taxes
The federal estate tax is also referred to by some as the death tax. It’s important to note though that the estate/death tax is not the same as an inheritance tax. The fundamental difference between an estate tax and an inheritance tax is who pays the tax. An estate tax is taxable to the decedent (the person who died, generally through his trust or estate). An inheritance tax is taxable to each recipient who inherited something.
There is no federal inheritance tax. Rather, inheritance taxes vary according to state law. Currently, there are approximately six states that have a state inheritance tax. Furthermore, there are approximately fifteen states, as well as the District of Columbia, that have their own state estate tax. It is possible that when you die, there will be a state estate tax, a state inheritance tax, and a federal estate tax. Generally, the payment of state taxes can be used at least in part to offset the federal estate tax through the use of a deduction.
Reducing Estate Taxes
What if someone’s taxable estate is greater than their coupon value? Can payment of the estate tax still be avoided?
There are a number of strategies used to combat the estate tax. These strategies vary from the more simple to the complex. Some strategies are better with certain assets than others.
As a planner, I have a variety of tools at my disposal in reducing or eliminating estate taxes:
- Lifetime Gifting – Using the annual exclusion amounts, we can make tax-free gifts annually in order to decrease the size of the taxable estate. Many times, the gifts are made not necessarily to a child specifically but, rather, to a trust for the child’s benefit. In this way, the gift stays outside the taxable estate of both the parent and the child. Appreciating assets are best to give because any future appreciation will also be out of your estate. Gifted assets keep your cost basis (what you paid for them), so recipients may pay capital gains tax when they sell.
Gifting is an underutilized tool. For example, if you are married and you have 2 children, both of whom are married, and 5 grandchildren, in 2020, you can transfer $270,000 a year tax-free!
- Purchase of life insurance – Purchasing life insurance in certain situations is a good way to pay for the estate tax and still have assets large enough to pass at death.
- Use of family limited partnerships/limited liability companies – FLPs and FLLCs let you reduce estate taxes by transferring assets like a family business, farm, real estate or stocks to your children now, and still keep some control. They can also protect the assets from future lawsuits and creditors.
You and your spouse can set up an LLC or FLP and transfer assets to it. In exchange, you receive ownership interests. Though you have a fiduciary obligation to other owners, you control the LLC (as manager) or FLP (as general partner). You can give ownership interests to your children, which removes value from your taxable estate. These interests cannot be sold or transferred without your approval, and because there is no market for these interests, their value is often discounted. This lets you transfer the underlying assets to your children at a reduced value, without losing control.
- Use of irrevocable trusts – As noted below, irrevocable trusts are a great tool in reducing or eliminating estate taxes. Which irrevocable trust we create depends on each situation.
It is very common to utilize more than one tool at a time. Thus, many times we may create an irrevocable trust and also use lifetime annual gifting, along with a family limited partnership. Each situation is unique and there’s no such thing as one-size-fits-all.
Use of Irrevocable Trusts
There are many kinds of irrevocable trusts, including the following, just to name a few:
- Bypass Trusts/Credit Shelter Trusts
- Qualified Terminable Interest Property Trust (QTIP)
- Irrevocable Life Insurance Trust (ILIT)
- Charitable Remainder Trust (CRT) and Charitable Lead Trust (CLT)
- Intentionally Defective Grantor Trust (IDGT)
- Grantor Retained Annuity Trust (GRAT)
- Hybrid Domestic Asset Protection Trust (DAPT)
- Spousal Lifetime Asset Protection Trust (SLAT)
- Nevada Incomplete Non-grantor Trust (NING)
- Qualified Personal Residence Trust (QPRT)
While these may look like alphabet soup, the general benefits of using an irrevocable trust are to: (1) minimize estate taxes; and (2) maximize asset protection.
Assets held inside of an irrevocable trust, if drafted correctly, can grow outside the taxable estate of the original owner of the property. This means if I gift a $1 million property into my irrevocable trust, I would have used $1 million of my coupon in making a taxable gift to my irrevocable trust. However, the benefit is that the property can now grow estate-tax free within the irrevocable trust! If I pass away 30 years from today, that $1 million real estate may be worth $10 million. In other words, I have passed on a $10 million property to my children outside of my taxable estate — no part of the $10 million is added in my estate tax calculation at my death and, hence, my estate will pay no estate taxes on the property. It’s as if I don’t own it, because – in actuality – I don’t (my trust does). Furthermore, if the trust is set up in the right jurisdiction, not only will I not need to pay estate taxes, but when my children die, they will not owe estate taxes either. Same with their children and onwards. We call this feature a “dynasty trust.”
Compare the result however if I had not created the trust. When I die, this $10 million property will be counted in my taxable estate along with all my other assets at death. If the total value is above my coupon value, there will be an estate tax upon my death. My children will then inherit the property, and when they too die (when the property is now worth $20 million), again, an estate tax will be due. Each generation will pay another estate tax on the same property, which will be appreciating over time as well.
Use of irrevocable trusts is instrumental especially before a large appreciation or liquidity event occurs. Trapping this growth outside your taxable estate will allow for the asset to grow free of estate taxes for multiple generations, while still offering protection against creditors, divorce, lawsuits, or judgments.
Click to read more in general about irrevocable trusts.