FUNDAMENTALS OF ESTATE TAX PLANNING
What are the fundamentals of estate tax planning, and how does these fundamentals relate to High Wealth families?
The first two principles of estate tax planning to consider:
PRINCIPLE #1: Estate taxes only apply to estates reaching a certain minimum size; estates less than that amount don’t pay estate taxes nor are they required to file death tax returns (though they can choose to file a portability death tax return); and,
PRINCIPLE #2: Any portion of an estate that ends up being subject to the estate tax means that a hefty 40% of any asset subject to estate taxes will go to the Federal government (ignoring potential state estate taxes).
NOTE: Estate taxes appear to have tax rates less than 40% for the first dollars taxed. However, those lower tax rates are “used up” in the calculation of what assets are protected by the estate tax credit.
This 40% estate tax is a lot more fearsome that it looks. The 40% is on the asset value NOT ON THE INCOME ACCRUING. For example on a $10,000 asset accruing annual 5% interest at a 40% INCOME TAX RATE would generate an annual tax of $250.00. Whereas an estate tax at 40% would generate an estate tax of $4,000.00 on the same asset. Big Difference! Between $250.00 and $4,000.00. If the asset or assets being taxed was $10 million, rather than $10,000, then the annual income tax would be $250,000.00 versus the estate tax of $4 million!
So the starting point in estate tax planning is determining that a family’s assets in the estate are either currently, or maybe at some future date, are subject to estate taxes. Secondly, keep in mind that assets subject to estate taxes are VERY, VERY expensive in estate taxes. Further fundamental estate tax principles are discussed below.
STATE ESTATE TAX NOTES: some states also have their own separate (additional) estate taxes, which are “over and above” the Federal Estate Taxes. Florida has no estate tax on persons a permanent resident of Florida. However, a Florida resident can owe state estate taxes if they own real estate (not usually liquid assets) in a state that DOES have estate taxes. Estate taxes are usually levied by the state where that person has a permanent residence, with the exception for real estate described above.
A few states tax any beneficiary that receives an inheritance, however, most states only tax the estate itself or have no estate taxes at all.
WHO ARE SUBJECT TO ESTATE TAXES, AND WHO CAN BENEFIT FROM ESTATE TAX SAVINGS STRATEGIES IN THEIR ESTATE PLANNING?
Federal Estate taxes are levied for assets that are not “protected” by the estate tax credit allowed. The current amount in June 2025 is just under $14 million. Estate planning is done in advance, and keep in mind that your assets could later grow above that amount. Also, Congress can lower that amount at any time.
Accordingly, the persons that can benefit from estate tax planning strategies are both single persons and couples with an estate near $14 million, or persons or couples with assets that may grow to that level before they both pass away.
BEWARE OF ESTATE TAX “CREEP.” One problem area is the simple fact that wealthy retirees’ net worth frequently increases over time. This increase in asset values over time, “creeping” forward to higher net worth can be a result of inflation only (due to excessive Federal spending triggering higher inflation). For example, a married couple may find theIr current net worth is somewhat below the level to be subject to estate taxes. But only too often a High Wealth family sees its net worth increase at a later date. Sometimes this occurs while both spouses are living, and sometimes after the first death of one of the spouses. If both spouses are living and competent, the couple can wait until the asset net worth increases beyond the tax level. However, once one spouse dies, it becomes much more tricky. Even if both spouses are still living, there may be competency issues or a reluctance to look at estate plans again as one gets older and older. Moreover there is also an issue of whether Congress may change (lower) the amount of assets that are exempt from estate tax. Were this to occur in a later Congress, it might prove to be wonderful foresight to have portability, credit shelter, or advanced estate strategies in place.
HOW DOES THE ESTATE TAX SYSTEM WORK?
The estate tax system starts by computing and including ALL assets that the decedent owned. All assets are included, including death benefit of life insurance (which may not be income taxable, but can’t be excluded from the estate tax unless in a special type of trust).
There are deductions allowable against the computed asset values. Such deductions include a charitable deduction for portions of the estate going to a qualified charity, and administrative expenses. Some examples of administrative expenses are legal and accounting costs, appraisal costs, and costs of managing estate assets.
The next step is to determine how much unified credit the decedent has to apply to protect a portion of the estate from being subject to the 40% estate tax. If the estate tax “unified credit” is expressed in terms of the dollar value that can be protected by such a credit, then the term “exemption equivalent” applies. The numerical amount of the credit is much smaller than the exemption equivalent, but both represent the same idea. Both represent the amount that can be passed tax free, before an estate starts to incur estate taxes.
The term “unified” in unified credit refers to the fact that Federal estate taxes are coordinated with Federal Gift taxes. If gifts were made before the decedent died, and such gifts were not sheltered by the annual gift tax exclusion, then the Gift tax return can use up part or all of the Estate tax Unified Credit. Use the allowable credit either during lifetime, or to pass assets in an estate. Either way the same overall global limit applies on the lifetime amount that a person can pass on tax free.
HOW TO CHOOSE BETWEEN THE TWO MOST BASIC STRATEGIES, THAT OF PORTABILITY OR CREDIT SHELTER?
Credit shelter strategies can give some ability for growth of assets to escape estate taxes. To do so, assets used for the first deceased spouse’s estate tax credit must be segregated in a separate trust. Portability is a different strategy that does not require assets to be segregated into a separate trust.
The clients can choose for that separate credit shelter trust to be maintained for the surviving spouse’s benefit. Hence, a credit shelter trust need not allow any have benefits from that trust for non-spousal beneficiaries until the surviving spouse later passes away. Allowing for the spouse to get the benefits of a credit shelter trust during their lifetime is not required by the Federal Estate Tax law. But many married couples want to ensure that the surviving spouse has adequate resources to maintain the same lifestyle.
Credit shelter trusts also can work very well in second marriages and blended marriages, and also in first marriages where there is an estate planning objective not to change the estate plan after the death of the first spouse. Such credit shelter trusts are tailor made to provide for a surviving spouse, while not allowing some or all changes in the estate plan.
Credit shelter trusts may be able to protect any future capital appreciation in the credit shelter trust from further increasing the amounts subject to estate taxes. Portability does not have that advantage.
On the other hand, Portability has the administrative advantage of not required a segregated trust. It simple to understand and also simple for a surviving spouse to administer.
However, to obtain the advantages of portability, the surviving spouse must file an estate tax return for the deceased spouse. This is so, even if the estate amount is below the amount where IRS requires the filing of an estate tax return. Such a portability estate tax return (IRS Form 706) is sometimes referred to as a “portability 706.”
It is possible to “stack” both strategies together. Credit shelter can be applied to any assets planned in advance for such a tax savings trust. However, portability can be claimed if the credit shelter trust does not fully exhaust the first deceased spouse’s estate tax credit. The use of one strategy does not prevent the use of the other at the same time.
Some action of some kind by a surviving spouse and/or a executor or successor trustee is necessary with either portability or credit shelter. For portability the action necessary is getting the “ledger credit” with the IRS by filing a portability 706. In contrast, implementing the credit shelter trust after the first death necessitates the surviving spouse or executor/trustee setting up the separate credit shelter trust.
The bottom line is that either portability or the credit shelter strategy will allow a married couple to potentially obtain both $14 million (approx) unified credits. Thus, a married couple can potentially shelter up to $28 million employing either portability or credit shelter. A married couple needing to consider sheltering even more than $28 million can employ even more advanced estate tax stategies, see below.
A single person can’t get more than the $14 million protected by the unified credit itself. However, a single individual can also consider the advanced strategies discussed below.
MORE ADVANCED ESTATE TAX STRATEGIES
What advanced estate planning strategies are available beyond the basic portability or credit shelter? How does each such strategy work? What clients can benefit from which advanced strategy? What are the limitations or downsides of each strategy?
Advanced strategies include charitable strategies which includes as an example CRTs — Charitable Remainder Trusts, GRATs —- a trust Grantor in which the client maintains an annuity payment for a specified number of years, SLAT — Spousal Lifetime Access Trusts, QPRT — Qualified Personal Residence Trust, Discounting value of assets strategies, Family Limited Partnerships and/or Business Succession Planning, Buy-Sell agreements in connection with family businesses, GSTs — Generation Skipping Trusts or Dynasty Trusts, ILITs — life insurance strategies (if your estate already including substantial life insurance policies), Private Foundations, and IDGTs — A trust that allows an elder generation member to increase the amount passing tax free to the next generation by having the elder generation cover income tax on income generated in the trust.
In the foregoing there is the “alphabet soup” of advanced estate tax planning. Many such advanced estate tax strategies are represented by an acronym, such as CRT or QPRT or ILIT. All these strategies involve planning to save estate taxes beyond the basic amounts allowed by the IRS for the unified estate tax credit.
Each of these strategies is complicated. Each involves unique advantages and disadvantages. For example, charitable strategies requires some amount of the estate to go to a charity. Some charitable strategies may also save some amount of income taxes. However, the total of both the income and estate tax savings will usually be less than the total net transfer to charity. These tax savings may offset a large amount of the transfer to the charity, but won’t add up to the full amount. Charitable strategies than probably not be a good choice by the many clients that don’t want that to happen. But any clients that are naming charity for any portion of their estate, however small, should consider such tax effective strategies.
The charitable discussion above is just an example. All the other “alphabet soup” advanced estate tax strategies discussed above have their own special client circumstances. Some such strategies relate to clients that have family owned businesses. Other strategies, such as SLATs, can be effective in second marriages (although can also be used in other contexts). If clients already have life insurance, the life insurance trusts can be considered. And so on; client’s unique circumstances and objectives need to be consdidered and addressed.
To find out more about such strategies, and which might be right for you, contact our law firm. Or contact your own tax advisor:
“Each client must engage strategies for savings of taxes; if you don’t do it, the IRS will happily just collect the higher amounts of taxes.”