You might, if you’re a U.S. citizen or permanent resident, and want to spare your heirs from paying estate tax at a rate as high as 55%. But don’t make your funeral arrangements just yet. Congress might change the law before the end of 2012.
In 2001, Congress radically retooled federal wealth transfer tax laws. The amendments raised the estate tax and lifetime gift exemption amounts, lowered the top estate tax rate, and eliminated the estate tax all together for 2010. At the end of 2010, Congress created a temporary “unified” gift and estate tax exemption of $5 million. Adjusted for inflation, the 2012 exemption is $5.12 million. (I’ll explain “unified” in a moment.)
But in 2013, estate taxes will revert to the 2002 threshold of $1 million. And should your estate exceed this value, your heirs will pay estate tax at a top rate of 55%—up from today’s 35%. And, don’t forget that for estate tax valuation purposes, your assets must be valued at their “highest and best use.” That’s the use that would produce the highest value for your property, regardless of how you currently use it.
It’s not uncommon for a family faced with a high estate tax valuation for real estate or a closely held family business to be forced to sell the business to pay the tax. If the value of the property falls in the months after your death, your heirs may wind up with an estate tax bill higher than the amount they inherited! While provisions exist in the Tax Code to reduce estate tax or spread out payment over time for family-owned farms and closely-held businesses, this is a poor substitute for advance planning to reduce avoid estate tax altogether.
The bottom line: if your estate exceeds $1 million, you’ll want to consider some ways to reduce your estate tax liability before Jan. 1, 2013.
Transfer Taxes 101
To ensure the bulk of your estate passes intact to your heirs or other beneficiaries, U.S. taxpayers and their professional advisors must consider three separate (but related) “transfer taxes.”
1. Estate tax. The $5.12 million exemption for 2012 doubles if you’re married and you do some basic estate planning.
2. Gift tax. For 2012, there is also a $5.12 million gift tax exemption. You can make gifts of up to $5.12 million during your lifetime to anyone you choose, with no gift tax liability. Again, if you’re married, the exemptions effectively double. However, for 2012, the gift and estate tax is “unified.” That means such “lifetime gifts” count against your estate tax exemption, dollar for dollar. You pay gift tax up to 35% on lifetime gifts you make that exceed $5 million.
In 2013, the gift tax exemption goes down to $1 million, with a top rate of 55% on gifts larger than that amount. It’s not quite as bad as it seems, because the gift tax and estate tax will no longer be unified; you’ll have a $1 million exemption for each.
Fortunately, you can make gifts to anyone up to $13,000 annually without using up any portion of this exemption. For example, if you’re married with four children and two grandchildren, you and your spouse can jointly gift each of your children and grandchildren 2 x $13,000 = $26,000 annually, or a total of $156,000 without counting toward the lifetime exemption.
3. Generation-skipping transfer tax (GSTT). This tax targets transfers that skip generations, since the assets won’t be included in the estate of the skipped generation. Every U.S. taxpayer has a lifetime GSTT exemption of $5.12 million. The GSTT is also unified with the estate tax, which means that gifts to your grandchildren that exceed $13,000 annually count against your estate tax exclusion.
In 2013, the GSTT reverts back to its level in 2001, $1 million, adjusted for inflation. I estimate the exemption will be approximately $1.4 million.
Planning Strategies for Avoiding Estate Tax
If you don’t plan on dying in 2012 to avoid estate tax, there are other options! Here are two simple ideas to consider:
- Marital bypass trust. If you’re married, this simple trust (sometimes referred to as an “A-B trust”) can double your estate tax exemption. You can also incorporate a marital bypass provision into an offshore trust formed in any suitable offshore jurisdiction. That way, you’ll obtain state-of-the-art asset protection for your wealth, and double the estate tax threshold.
- Lifetime gifts. Since you have a $5.12 million gift tax exemption until the end of 2012, why not use it? If you own assets that have substantially fallen in value in the last year or two, consider gifting them to your loved ones now, before values recover. Just don’t forget about the unified estate/gift tax exemption. Every dollar you gift above $13,000 per recipient per year counts against your estate tax exemption. In addition, unlike property received through inheritance, property received as a gift doesn’t benefit from a “step-up” in basis. The recipient of the gift must eventually pay capital gains tax on the difference between the selling price and the price at which you acquired the property. With inherited property, the acquisition price “steps up” to its value at your death. In addition, there is a drafting error in the 2010 law that temporarily increased the unified estate and gift tax exemption to $5 million. This error could result in higher estate taxes for your heirs if you make lifetime gifts larger than whatever lower estate tax exemption is eventually imposed. However, this drafting error will hopefully be corrected.
In my next post, I’ll describe some more advanced techniques to avoid estate taxes. They’re especially important to consider if you have a large estate.
Copyright © 2012 by Mark Nestmann