Estate Tax Basics: Inclusions and Deductions

What is the estate tax and who pays? Estate taxes can cut into your legacy. When you die, they're imposed on your net estate value after deductions from your gross estate. Your gross estate is the value of all property in which you have any interest at your death plus items you gifted within 3 years of death.

The estate tax return must be filed within nine months after the decedent's death, although you can file for a six month extension. Valuation of the estate can be made either at the date of death or six months later (sometimes, if for example, stock in the estate have fallen in value, it will be better to value the estate at the later date). Below we look at how estate tax gets calculated.

What property interests are included in your gross estate?
Included is the value of all your property interests such as:

Any assets that you own individually and outright.

Half or all Jointly-owned assets:If held with rights of survivorship between husband and wife, then one-half of the value of such joint property is included in the gross estate of the first joint tenant to die and the other one-half is excluded from the gross estate.
If held with right of survivorship between persons who are not husband and wife (e.g. parent-child or brother-sister), then the entire value of any joint property is included in the estate of the first joint tenant to die, unless the estate can affirmatively prove that the surviving joint tenant supplied some or all of the money used to purchase the joint property. For this and other reasons, it is a bad idea to hold assets jointly with children thinking it will make the estate transition easier.

Life Insurance proceeds on your life if:

the policy proceeds are payable directly or indirectly to your estate; or
you held any incident of ownership in the policy, such as the right to change the beneficiary, surrender or cancel the policy or borrow against the policy. For this reason, you never want to be the owner of your own life insurance policy. In general, it should be owned by the beneficiaries.

The value of gifts made within 3 years of death since they are considered as given in contemplation of imminent death. Of course this is not logical, but you cannot argue with IRS.

What are the estate tax deductions from your gross estate which help to reduce the estate tax?
You can deduct funeral expenses and expense incurred in administering the estate property for estate tax purposes, net losses during the administration, debts of the decedent, mortgages and liens, and charitable, public, and similar gifts, and lastly, but most significantly - the marital deduction.

The marital deduction includes any bequest to the surviving spouse and is unlimited. But it's allowed only where

the marital bequest goes to a legally recognized spouse,
the surviving spouse is a citizen of the United States, and
the marital bequest is included in the value of the gross estate.

Full use of the marital deduction to eliminate your estate taxes may produce a highly taxed estate at your spouse's death which can then cut into your children's legacy. That is why IRS permits you to leave an unlimited amount to your spouse without taxation as they will eventually get their estate tax when your spouse dies (and more of it for reasons we won't cover in this post). Use a by-pass trust to help eliminate this consequence.

Estate tax laws are once again up for debate in Washington D.C. But no matter what the outcome of the negotiations will be - whether estate taxes will be repealed or reinstated after the year 2012 -estate planning should not be placed on hold. Your benefits will likely never be better than they are now. Currently, federal estate taxes are incurred on estates that are in excess of $5.12 million ($10.24 million if married) and these figures will fall to $1 million and $2 million in 2013. Preparing today for the efficient transfer of your wealth is a move that could pay off in the long run.

One tax-efficient way to pass along your wealth to heirs, with greatly reduced estate tax liability, is an irrevocable life insurance trust (or ILIT). ILIT's were created to shelter life insurance benefits paid to beneficiaries from estate taxes. Although life insurance benefits are not subject to federal income tax, they can be included in an estate upon the death of the policy owner and subject to federal estate taxes.

Here's how it works: as the estate owner, you create an ILIT and name a trustee to administer it. You cannot be named as the trustee, so it is sometimes advisable to name an attorney, CPA, trust company, or financial institution as the trustee for the ILIT. Also, at the time you create the ILIT, you name the beneficiaries and direct how the trust funds will be distributed upon your death. Then, you deposit money into the ILIT and you have the irrevocable life insurance trust purchase a life insurance policy, naming the trust as the beneficiary. Note that because of the high estate exemption in 2012, your tax-free (i.e. free of gift tax) transfers to the trust can be much larger than next year.

Upon your death, the proceeds from the life insurance policy will be paid to the ILIT, which will then distribute the funds as you directed in the trust documents. For example, you could state that one-half of the life insurance proceeds be paid to your beneficiaries at the time of your death, with the remainder paid out at a later date.

Your beneficiaries could also use the proceeds to pay the federal estate taxes or even the state inheritance taxes due on other assets they receive from your estate. This may be an ideal strategy for you if some of the assets in your estate are illiquid (e.g., real estate.)
The effectiveness of an irrevocable life insurance trust as an estate-planning tool is dependent on your insurability. If you cannot obtain a life insurance policy for health reasons, or if the policy is too cost-prohibitive, using an ILIT may not be available to you. Please also note that fees and other expenses will apply with the purchase of life insurance, and surrender charges may be applicable on money withdrawn or benefits reduced after the policy is purchased. Insurance benefits and premiums also vary from company to company. Insurance guarantees are subject to the claims-paying ability of the issuing company.
In conclusion, the irrevocable life insurance trust could prove to be an effective wealth-transfer strategy.

Bequeathing investments to children and grand kids in your life-time is a type of tax planning for controlling your property. In this way, you can lower your estate as well as your beneficiaries inheritance tax exposure. However, there are other factors to think about, as you share your wealth with future generations -- not the least of which are the tax consequences you could incur while giving assets including cash, securities, or property to children.

In view of the cash-contribution limitations for 529 Programs, the tax planning of employing UGMA and UTMA accounts may offer greater flexibility for transferring resources to kids. UGMA and UTMA accounts are easy to setup, and most mutual fund and economic service companies offer them. Resources can include money and securities could be transferred into a UGMA or UTMA account and managed at your direction. On drawback, nevertheless, is that the minor gets possession of the account at the age of 18 or 21 (based on state guidelines) - an age at which most children have yet to develop financial sensibility. Also, the income from the underlying investments is subject to state and federal income taxation. Capital gains taxes can also occur in case the resources are sold for an income. Basically, different tax planning to move investments have offsetting pros and cons.

Numerous mothers and fathers and grandfathers and grandmothers seek to offer financial assistance to their children and grandkids for educational and college costs. Section 529 Plans are among popular tax planning for financing higher education costs. Under current federal law, any revenue from all of these plans accumulate on a tax-deferred basis and upcoming withdrawals are tax-free is used for certified higher-education expenditures. Furthermore, these types of programs allow for initial contributions of up to $65,000 with out incurring a federal gift tax ($130,000 for a married couple). When this is completed, the $13,000 annual gift-tax exclusion is pro-rated over following 5 tax years.

However, these types of plans have several limitations and several people choose other tax planning strategies. With 529 accounts, all contributions should be made in money, and the assets in a 529 account must be invested in the investment alternatives provided by the state-sponsored plan. This means you cannot move non-cash resources including shares or mutual fund shares to a child's 529 account. The actual investments in these programs are securities and may be subject to market unpredictability and variation. Pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), certified withdrawals are federal income tax free.

As previously mentioned, the yearly federal gift tax exclusion is $13,000 per individual ($26,000 for married couples). The tax planning of gifting has its restrictions. This annual gift exclusion applies to present interest gifts only. Therefore, the question of what constitutes a "present" and a "future" interest as it relates to the exclusion that may present real planning problems with some gifts to minors. Furthermore, while outright gifts to minors pose no certain gift exclusion issues, there are practical, property management obstacles that appear with larger gifts. Actually, several states restrict a minor's legitimate right to purchase, look after, sell, or transfer property.

There are several tax planning strategies for gifting resources to kids, just a few of which are covered in this posting.

We have many articles on estate planning in this blog so just use the search function for further reading.