What is a Disclaimer Trust?

A Disclaimer Trust is a special type of trust often created under a Will (or as a sub-trust of a revocable living trust) that generally allows a person to refuse an asset and still benefit from it under a trust.  In order to understand Disclaimer Trusts, you first need to understand what a disclaimer is and what happens when you make a disclaimer so that you can understand the purpose and mechanics of Disclaimer Trusts.

What is a Disclaimer?

A disclaimer is literally when someone refuses to accept money or an inheritance.  A person can disclaim a gift, an inheritance, an interest in a trust, or certain powers.  (Let's call this the "Disclaimed Interest".) A person can also make a partial disclaimer, such as disclaiming half of their inheritance (although special rules apply to this).

What Happens When a Disclaimer Is Made?

When a Disclaimer is done correctly, it has the affect of treating the person who disclaims as if he or she died prior to the Disclaimed Interest being made.  So, if a Wife is disclaiming an inheritance from her Husband, it treats the Wife as if she had died before the Husband for whatever amount Wife disclaims.  Generally, in order for a disclaimer to be effective for tax purposes, it must be done within nine months from the date of death AND the beneficiary cannot have accepted the Disclaimed Interest.

Since the Disclaiming party is treated as if he or she died before the gift or bequest was made, the Disclaimed Interest will pass to the next person in line who is suppose to receive that.  For example, if a Will says, everything to my spouse, and upon the death of my spouse, it all goes to my children, then if the surviving spouse disclaims her inheritance, it would all go to the children.  However, that may not be the result the surviving spouse wants.  She might want to have access to that money during her lifetime and only have it go to the children upon her death.

What is the Purpose of a Disclaimer Trust?

The purpose of a Disclaimer Trust is that it allows a surviving spouse to inherit money, but to do so in a way that would be more tax efficient for the descendants of the person creating the Will.

This tax efficiency is probably best illustrated by two examples of how it affected NJ residents prior to 2017.  Back when NJ had a state estate tax, it often wasn't beneficial for the surviving spouse to inherit everything outright. New Jersey had a 'use it or lose it' state estate tax exemption of $675,000.  So, if a married couple owned $1,350,000 of assets, and when one spouse dies they wish everything to go for the benefit of the survivor and then down to the children:

1. Example 1 - Upon the first to die, everything goes to surviving spouse outright.  When the second spouse dies, she would only have one NJ estate tax exemption of $675,000.  So assuming no growth in assets, the remaining $675,000 would have been subject to the NJ estate tax, resulting in a tax of almost $55,000.
2. Example 2 - Upon the first to die, everything goes into trust for the surviving spouse.  This utilized the estate tax exemption of the first person to die.  The surviving spouse still had access to the funds in trust, but when she died and everything went to the children, there was no NJ estate tax because she also had an estate tax exemption.

Under What Circumstances Should a Surviving Spouse Disclaim Assets into a Disclaimer Trust?

A surviving spouse should disclaim an inheritance into a Disclaimer Trust when it would be tax efficient to do so.  If we go back to our example above, let's say the couple with $1,350,000 has their estate dwindle down to $500,000, or they move to another estate without a state estate tax, or the estate tax exemption has increased well beyond what they expect to have when the surviving spouse dies, there would be no point in the surviving spouse disclaiming. 

If it is highly like that the surviving spouse will live in a state that has a state estate tax, and it the surviving spouses assets (including the inheritance) would be above that state's estate tax thresh-hold, then it often beneficial for the surviving spouse to disclaim the assets into a Disclaimer Trust.

(Incidentally, before the federal government had portability between spouses of the federal estate tax exemption, this was a part of practically every single Will for married couples.  Since portability and the increase the federal estate tax thresh-holds, fewer attorneys are including these clauses unless the state has an estate tax.)

When Should a Surviving Spouse Disclaim Assets into a Disclaimer Trust?

For a disclaimer to be effective for tax purposes, it must be done within nine months from the date of death.  The nice thing about Disclaimer Trust planning for couples is that it allows the surviving spouse to take a look at all the facts and circumstances when the first spouse dies.  

It is important to remember that the funding of a Disclaimer Trust is always optional.  A disclaimer Trust will NOT get funded unless the surviving spouse makes files a qualified disclaimer according to local state rules.  You can analyze your wealth situation, need for cash, look at the tax laws and figure out what is best for your situation.

What are the Tax Consequences of a Disclaimer?

If a Surviving Spouse disclaims within the nine period and does so according the rules set out by the IRS (basically not taking the property first, not directing where the disclaimed property goes, and complying with state rules on disclaimers), then the disclaimed amount will be includible in the decedent's taxable estate.  This is generally what you want as you are disclaiming to utilize the decedent's estate tax exemption amount.

The person disclaiming must be careful not to disclaim too much, otherwise that might trigger an estate tax on the first to die.

It should be noted that failing to disclaim in a timely fashion or in a way proscribed by the IRS will result in the disclaimer be treated as a taxable gift by the Disclaimant.  Basically, it's as if the surviving spouse accepted the property and then gifted it away.

Alternatives to a Disclaimer Trust Plan

The question I always ask my clients is whether or not they want to guarantee that money go into trust for the surviving spouse.  If they want to guarantee the use of an estate tax exemption or if they want to protect the money from a future spouse, we wouldn't do a Disclaimer Trust plan, we would just automatically fund a trust for the benefit of the surviving spouse upon the death of the first spouse instead of giving the surviving spouse the option to fund it upon the first to die.

However, many people aren't concerned about the surviving spouse remarrying, and they want to keep things simple.  Usually in those cases, we would allow the surviving spouse to disclaim their inheritance into a Disclaimer Trust upon the first to die if there is a tax reason to do so.

If the surviving spouse really doesn't need the money, he or she can also take the money and gift it to the children (or wherever you wish). Remember, this can result in a taxable gift.  However, with the high estate and gift tax exemption limits ($11.2M per person in 2018), most people will not actually incur a gift tax unless you make a very large gift.

Who Can Make a Disclaimer?

Throughout this post I have talked about the ability of a Surviving Spouse to make a disclaimer, and while anyone can disclaim an asset, only a Surviving Spouse can disclaim an asset in to a trust for the benefit of himself or herself.  The general rule for anyone other than a surviving spouse is that you cannot disclaim money and still benefit from it.  Accordingly, your child can never disclaim into a trust for his or her benefit.  

On the other hand, attorneys frequently create estate plans that give money to child, but if child dies, her share goes to grandchild in trust.  If the child is wealthy, she might not want or need the money and then Child can disclaim funds into grandchild's trust and act as trustee of that trust.

Problems With Disclaimer Trust Planning

The biggest problem with Disclaimer Trust planning is that the surviving spouse often fails to make an effective disclaimer.  If the surviving spouse doesn't seek counsel within nine months of the first spouse's date of death, or they transfer money into their own name, then an effective disclaimer cannot be made.

Balancing Estate Tax Planning and Capital Gains Tax Planning

One of the trickiest aspects of deciding whether or not to do a disclaimer is calculating whether a disclaimer will minimize overall taxes and expenses.  If the assets are in the surviving spouse's name, it can be subject to extra estate taxes.  If the assets are titled in the name of a Disclaimer Trust, it could produce additional capital gains taxes, accounting fees and other costs.  I would strongly urge you to consult with a tax attorney before exercising a disclaimer.

How Do I Know if My Estate Plan Includes a Disclaimer Trust?

The Will or Revocable Trust usually says something to the effect of "I leave everything to my spouse, but if my spouse disclaims all or a part of his or her inheritance, such disclaimed portion will be distributed pursuant to the Disclaimer Trust created hereunder."

A surviving spouse should be careful of disclaiming if no Disclaimer Trust is established under the Will or Revocable Living Trust as a disclaimer could have the effect of sending everything to the children.

If a Disclaimer Trust is Primarily for Married Couples Living in a State That Has a State Estate Tax, Why Do My Documents Have a Disclaimer Trust?

Disclaimer Trust planning is most useful in states still have a state estate tax.  However, many attorneys will automatically put it in the estate planning documents for a married couple even if they live in a state that doesn't have a state estate tax just in case the client moves to a jurisdiction that does have the tax.  Moreover, it was common practice to do Disclaimer Trust planning prior to 2001 when the federal government allowed spouses to port their unused federal estate tax exemption to the surviving spouse.  Accordingly, there is a historical component to this in all states.

Is there Any Harm to Having a Disclaimer Trust in my Will or Revocable Trust Even Though I Know I Will Never Use It?

Attorneys never like to use the word "never".  So, I will say that it would be very surprising if there is any harm in having a Disclaimer Trust in your Will or other estate planning documents.  It is a great failsafe.

7 Simple Ways to Minimize the Pennsylvania Inheritance Tax

It's been a little while since I have written an article on the Pennsylvania inheritance tax.  However, before I discuss ways to minimize the PA inheritance tax, it is important to understand that the tax rate is affected by who receives money upon your death.

As a refresher, Pennsylvania has an inheritance tax on most assets that are transferred at the time of your death if they are going to anyone besides a spouse or a charity.  There is also no inheritance tax if a child under age 21 dies and leaves their estate to their parent or step-parent.

Pennsylvania Inheritance Tax on Assets Passing to your Children, Grandchildren, Parents and Grandparents

• There is a flat 4.5% inheritance tax on most assets that pass down to your children, grandchildren, great-grand children or your other descendants.
• There is a flat 4.5% inheritance tax on most assets that pass up to your parents, grandparents or your other lineal ascendants. (Exception if the decedent is under age 21.)
• Pennsylvania treats a son-in-law or daughter-in-law as if they are a child for purposes of the inheritance tax.  As a result, there is a flat 4.5% PA inheritance tax on assets that pass to the wife or widow and husband or widower of the decedent's child. 

Pennsylvania Inheritance Tax on Assets Passing to your Brothers, Sisters, Nieces, Nephews, Friends and Others

• There is a flat 12% inheritance tax on most assets that pass to a sibling (brother or sister).  
• There is a flat 15% inheritance tax on most assets that pass up to nieces, nephews, friends and other beneficiaries. (This means there will be 15% tax on money you leave to your dog, cat or horse.)

7 Simple Ways to Minimize the Pennsylvania Inheritance Tax

1. Set up joint accounts with the people you wish to benefit.  Pennsylvania will only tax the percentage of assets owned by the decedent, not the full amount.  
• This is a particularly useful strategy if you have one child that you trust completely as only one-half of the jointly owned assets will be taxed.  However, if you have more than one child, it is possible that you and all the children are joint owners of the account, so if you have three children, only 1/4 of the account will be subject to the PA inheritance tax.
• If you have more than one child, be careful of setting up a joint account with just one person (because you may accidentally cut your other children out)
• Be sure that you don't have any concerns that your child will take your money and it won't be available for you to use.
• Transfers must occur more than one year before death to achieve the maximum tax benefit.
2. Gift your assets to your children.  This can be a very dangerous strategy, so I strongly recommend consulting with a tax attorney or accountant before making the gift.
• Dangers include giving away an asset that has a low basis resulting in a capital gains tax which could be far more expensive than simply paying the PA inheritance tax.
• If you give away too much, you could be subject to federal gift taxes or generation skipping transfer taxes.
• This could potentially cause problems if you wish to qualify for Medicaid.
3. Buy extra life insurance.  Life insurance is not subject to the Pennsylvania inheritance tax, so converting non-life insurance assets to life insurance will reduce the tax.
• An interesting planning opportunity is to by a long term care insurance policy that has a life insurance rider.  This way if you don't use up the LTC policy, it can pass tax free to your heirs.  
4. Utilize life insurance to give money to beneficiaries who are taxed at the highest tax rates.  So let's say you have total assets of $1.1 million dollars including a life insurance policy worth $100,000, and you want to leave $100,000 to your nieces and nephews and you want to leave the rest of your estate to your children.  
• If you have name your nieces and nephews the beneficiary of the life insurance and give the rest of your assets to your children, there will be a total PA inheritance tax of $45,000 (4.5% x $1M).  
• If you give the children the life insurance money, and have a will leaving your nieces and nephews $100,000 from your Will with the rest to the children, the total PA inheritance tax will be $55,500 (15% x $100,000 + 4.5% x $900,000). 
5. Buy real estate outside of Pennsylvania.  OK, maybe this isn't very simple, but Pennsylvania only taxes assets located in Pennsylvania, so a shore property in New Jersey will pass free of the PA inheritance tax.
• Beware of taxes in other states
• Don't put the real estate in an entity such as an LLC - Pennsylvania reserves the right to tax an interest in business.  (The legal theory is that you no longer own real estate, but the LLC, which is subject to a PA inheritance tax.)
6. Pay the PA inheritance tax early.  If you pay the Pennsylvania inheritance tax within 3 months from date of death, you are entitled to a 5% discount.
7. Convert your IRA to a Roth IRA.  The conversion will come at a cost to your current non-retirement assets, thereby reducing your PA taxable estate for inheritance tax purposes.
• This strategy works best when you have enough funds outside your retirement account to pay for the income taxes on the conversion.
• This strategy is especially valuable if your children are high income earners, this way they can receive distributions from the ROTH, after your death, free of income tax.
• I strongly recommend consulting with a tax attorney or accountant though before doing the conversion.  

Other Not-So-Simple Ways to Minimize the PA Inheritance Tax

1. Move to another state.  Again, this may not be simple for many people, but if you already have a property in another jurisdiction, consider whether you should change your domicile for tax purposes.  (Obviously you must actually meet the requirements of changing your domicile.)
2. Invest in farmland or a family business.  Pennsylvania exempts certain farmland and small businesses from the inheritance tax.  The problem with this may be getting your money back out of the business.
3. Setting up a GRAT or GRUT (setting up a special type of trust that creates an annuity back to you and gives excess investments to your heirs).
4. Setting up a CLAT or CLUT (setting up a special type of trust that creates an annuity to charity and leaves the rest to your heirs).
5. Setting up a CRAT or CRUT (setting up a special type of trust that creates an annuity to your heirs and leaves the rest to charity).
6. Setting up a spousal access trust.  These are typically over-funded life insurance trusts.  Money can be used for your spouse and children while your alive and then it goes completely tax free to your children.  This is a fantastic way to minimize the federal estate tax as well as minimizing the PA inheritance tax.

Simple is Never Simple

As always, be very careful that any changes you make to beneficiary designations or joint ownership of accounts could dramatically alter your overall plan.  So it never hurts to run what might seem like a simple change by an estate planning attorney.

Change to Estate Tax Exemption Limit for 2018

While the House and Senate are considering competing tax proposals, including a proposal to eliminate the federal estate tax, it is worth noting that the IRS has release Revenue Procedure 2017-58 which provides inflationary updates for a number of provisions in the Internal Revenue Code.

Assuming that the Republicans do not pass a bill that modifies the existing estate tax and gift tax structure, for 2018:

1. US Citizens and Permanent Residence Aliens can pass on $5,600,000 per person upon death or during their lifetime.  The federal estate tax exemption is also known by several other terms including the lifetime gift exemption, the basic exclusion amount, and the unified applicable exclusion amount.   The exemption is being increased by $110,000 from its 2017 limit of $5,490,000;
2. The annual gift tax exclusion will increase to $15,000 per person, per donee.  This is up from $14,000 in 2017; and
3. The annual exclusion for gifts made to a non U.S. Citizen spouse has been increased to $152,000.  This is up from $149,000 in 2017.

This revenue procedure does not change any laws.  It is simply designed to inform taxpayers of any changes in tax provisions as a result of inflation. 

Estate Tax Thoughts on a Trump Presidency

It is no secret that most Republicans and Donald Trump wish to get rid of the federal estate tax (or as it is commonly referred to "The Death Tax").  With Republicans in charge of the House, Senate and Presidency, I think we are very likely to see a full repeal.

Many will counter that George H.W. Bush could not get a full repeal with Republicans in control of all 3 parts of the government.  I will suggest to you that those days are long gone.  There are no more moderate Republicans to push back against a full repeal, and President Trump has an incredibly personal vested interest in keeping his empire intact for his children.

There is a small chance of a filibuster against it, but I still see a strong likelihood that the federal estate tax will be gone by 2018.

Reasons to Value a Trust

Recently I gave a lecture on the valuation of trusts.  While I am not an accountant nor am I a valuation expert, I live and breathe trusts... and frequently the question comes up, what is value of a particular beneficiary's interest in a trust.

Keep in mind, just because a trust is worth $1M, it does not mean that the beneficiary's interest is worth $1M if they have limited rights to invade the trust or control it.  Here's are a few reasons to value a trust:

1. When a person dies, that person may have a beneficial interest in a trust.  Depending upon the type of interest a person has, it may or may not be includible in his/her taxable estate.  If the interest is includible in the deceased beneficiary's taxable estate, then the executor of the deceased beneficiary must report it on federal and state estate tax returns. 
2. Similar to the above, but slightly different, when a person dies, he or she may leave a beneficial interest in a trust to another person.  Particularly in New Jersey and Pennsylvania, you see this come up a lot when a person leaves money to a class A beneficiary in trust (such as a spouse), and then the remainder interest to an non class A beneficiary (such as a nephew or niece).  This triggers something known as the Compromise tax.
3. Financial Aid - Some colleges and schools will look at the trust terms, others won't.  Each school is different regarding the questions they ask on their forms.
4. Divorce.  Depending upon the state, a person's interest may be subject to equitable distribution, alimony and especially child support.  

• New Jersey tends to be fairly friendly to a trust beneficiary.  See Tannen vs. Tannen, where the Appellate Court ruled that a beneficiary's income interest should not be imputed for purposes of alimony.  The general rule was already that such an interest was not subject to equitable distribution.  (NOTE:  This case law is likely to be challenged in light of the fact that NJ recently enacted the Uniform Trust Act. 
• Pennsylvania is far less friendly to trust beneficiaries.  The general rule in Pennsylvania is that marital property does not include trust property acquired by gift, bequest, devise or descent prior to or during the marriage, but it does include the increase in value of such property. See 23 Pa. Cons. Stat. 3501(a.1)   
• As far as I am aware, both Florida and New York follow the NJ rule and generally considers trust property as separate property, not subject to equitable distribution.  
• Massachusetts recently came down with a terrible case:  See Pfannenstiehl.   (Note: I'm not licensed in MA)

Regardless of the reason why you need to value a trust, the first step in determining the value is to figure out what type of interest that person has.  Usually a beneficiary's interest includes one or more of the following:

• An income stream
• The right to receive income or principal for health, education, maintenance and support
• An annuity stream (such as $2000/month)
• Principal distributions once the beneficiary reaches a certain age
• The right to take out $5000 or 5% per year
• A discretionary interest

Once you have figured out a person's interest in a trust, the next step usually involves hiring a certified appraiser to figure out the value of a person's interest. A trust attorney can assist the appraiser by advising them on the nuances of the trust and not-so-obvious options that a person may have in invading a trust.  

If you are the beneficiary of a large trust, I would recommend that you have the trust reviewed to see if you should disclaim and renounce certain powers to minimize taxes upon your death.  

Requirement of Executors to Report Basis of Assets When Administering an Estate - FollowUp

The IRS has released new regulations that have extended the due date for filing Form 8971 to March 31, 2016.  Executors and administrators of estates that are required to file a federal Form 706 Estate Tax Return are now also required to file Form 8971 and report the basis of the assets included in the estate to the beneficiaries of the estate.

As discussed in my post on February 7, 2016, the IRS is trying to consistently tax assets for estate tax and capital gains tax purposes.  Requiring executors to supply this information to beneficiaries and the government is their attempt to better track this information.  

Additionally, there was an open question as to whether all estates had to file the Form 8971 or just those that were over the federal estate tax exemption threshold.  According to this publication from Bessemer Trust, the IRS has issued regulations that state that if you are filing a form 706 merely to elect portability, you do not also need to file form 8971. 

Thanks again to Abby Moller for bringing this to my attention 

IRS Releases Form 8971 - Executors Now Required to Report Basis of Assets When Administering Estate

For many years the IRS and beneficiaries of estates had a problem figuring out how much gain should be imposed on an inherited asset because the beneficiaries did not know the basis.  The IRS did not like the fact that frequently the value reported by an Executor was not the value reported by a beneficiary when an inherited asset was sold.   

Accordingly, the government enacted Internal Revenue Code Section 1014(f) and is requiring that any estate which is required to file an estate tax return (Form 706) also file Form 8971 (including all attached Schedule(s) A), retro-active to decedents who died after July 2015. The executor must also provide Schedule A to each beneficiary receiving assets from the estate. Both requirements must be met within 30 days after the date on which Form 706 is required to be filed with the IRS, or the date that is 30 days after the date Form 706 is filed with the IRS, whichever is earlier. 

Notice 2015-57 has made February 29, 2016 the due date for all Forms 8971 (including all attached Schedule(s) A) required to be filed with the IRS after July 31, 2015, and before February 29, 2016. Penalties may be imposed for failure to comply with this new filing requirement.

If an estate is not required to file a Form 706, then there is no corresponding requirement to file a Form 8971.  However, it is probably good practice for the executor to advise the beneficiaries of the value of assets as determined on a decedent's date of death so that everyone knows what the new basis is in the inherited assets. 

Instructions for Form 8971 can be found here: https://www.irs.gov/instructions/i8971/ch01.html

I note that there are a number of important items that are not clear:
1)  Does Form 8971 need to be filed when an estate files Form 706 for purposes of porting the DSUE of a deceased spouse. Accordingly, until we receive clarification, it would probably be best practice to do so.

2) Which beneficiaries should actually receive a copy of the Form?  For example, it would make sense to give the form to the beneficiaries of a trust.  It would make more sense to give it to the trustee of a trust.

3) Form 8971 asks "Did this asset increase the estate tax liability?"  I am a little unclear on what this actually means.  I would think that you should pretty much always answer yes to this question.  However, I have heard one commentator state that this really muddies the waters because theoretically assets that qualify for the Marital Deduction, Charitable Deduction, or other similar deductions do not increase the estate tax liability.  Nevertheless, I do not believe the IRS now saying we don't get a step up in basis for those assets.  I believe this is primarily to identify non-qualified preferred stock options and potentially negative value assets.  After all, it would be shocking for the IRS to say that assets passing to a spouse do not receive a step up under the normal 1014 basis rules.  If I here otherwise, I will be sure to let you know... and join in the revolt against the politicians!

4) What about situations where a beneficiary is actually allowed to have a basis higher than a decedent's date of death value?  Examples of this potentially include:  situations where a beneficiary gifted away an asset within one (1) year of death, where a decedent dies owning an interest in a partnership or limited liability company subject to a debt, or real estate subject to a non-recourse debt. 

The American Bar Association Taxation Section has submitted a letter to the IRS requesting clarification of many of these items.  I hope we will all hear a response soon.

-----------
Updated 3/23/16 - Thanks to Abby Moller for finding a few typos in this article. Additionally, she has advised me that apparently you do not need to file Form 8971 just for purposes of portability.  I will try to find additional support for this.

2016 Federal Estate Tax Exemption Amount

The IRS recently released Revenue Procedure 2015-53, announcing the inflation adjustments to many tax provisions.  Of note, the unified credit against the federal estate tax for Calendar Year 2016 is $5,450,000.  This is up from $5,430,000 in 2015.

The annual gift tax exclusion of $14,000 per person/per donee remains the same.  However, the annual gift exclusion to non citizen spouses has increased to $148,000 from $147,000.

The Difficulty of Porting a Deceased Spouse's Unused Exemption Amount in Second Marriage Situations

Many estate planning commentators have joked that estate tax portability will lead to rich individuals marrying others simply to make use of their estate tax exemption.  I have found, in practice, that planning can be far more complicated.

Let me take you through a common situation that I am dealing with:
1) I represent a wealthy person (let's say $10M+) who is married to someone not as well off, but not poor (about $1M);
2) Each spouse has children from a previous marriage; and
3) The spouse who has less money has no real desire to give money to the surviving spouse and wants everything to go to his/her children.

I'll call the wealthy person Wendy and the less wealthy spouse Harry.  In a situation like this, if Harry dies first, and leaves his entire $1M to his children, then he will only have used up $1M of his $5.43M federal estate tax exemption.  Wendy is entitled to receive the Deceased Spouse's Unused Exemption Amount (DSUEA) of $4.43M.  This concept is known as portability and would increase what she can pass on to her children tax free from $5.43M to $9.86M - an estate tax savings of $1,772,000.

Now, if Harry is leaving everything to his children, it is likely that one of them is the Executor, and not Wendy.  This is important because the only way for Wendy to receive the DSUEA is for the Executor of Harry's estate to file a federal estate tax return.  Harry's executor might not want to incur the trouble or expense of filing a return that does not benefit them in any way.  After all, there is no need to file the federal estate tax return if the estate is less than $5.43M.

If Wendy gets along well with the Executor, she can agree to pay for the return, but that is no guarantee.  The safest approach to ensure that Wendy has access to Harry's DSUEA is to get Harry to redo his Will and make a specific bequest of his DSUEA to Wendy AND require the executor to file the federal estate tax return (or do whatever is necessary to ensure that the wealthier spouse actually gets to port his unused estate tax exemption amount).

Harry can of course require that Wendy pay for all costs associated with such return, which I would imagine she would be happy to do.  After all, a federal estate tax return, even on the expensive side, is likely to save Wendy's heirs millions of dollars.

Non-residents Non-citizens of the US Should Be Careful of How they Invest in American Assets

Many individuals who live outside of America like to purchase real estate in America or invest in the U.S. Stock Market.  It can be much safer than in investing in other parts of the world and often times the individual has children who have moved to America to live or study.

Florida and New York are particularly attractive locations for foreigners to buy vacation homes or rental properties, so I will focus on those jurisdictions a bit.

From a tax perspective, Florida is relatively easy to deal with as there is no estate tax. The transfer taxes are small and the process is pretty quick if you need to transfer the property during your lifetime. New York recently changed its estate tax laws, so that individuals can soon transfer over $5,000,000 before there is a state estate tax.  Transfer taxes are a bit higher and the process is a bit slower, but it is not terrible.

On death, it is a different story, both Florida and New York can be a royal nightmare and you should avoid probate.  Probate is the process of transferring assets on death and is typically quite expensive. It is also very easy to avoid by setting up a simple trust that is invisible for taxing purposes. A trust can also be set up to avoid the US federal estate tax, and I strongly recommend this.

With respect to the US taxes, a foreign investor must worry about both income taxes AND estate taxes.  While owning stock or real estate outright may be easiest and perhaps even best to minimize income taxes, it can be the worst thing to do for estate taxes.

The United States is not very friendly when it comes to foreign individuals who wish to transfer property in America. While a US citizen or resident alien may transfer $5,340,000 before there is a gift or estate tax, the threshold for non-resident is $14,000 for gifts (per person per year) and only $60,000 (total) on death.  A person may gift $145,000 (annually indexed for inflation) to a non-citizen spouse before there is a US gift tax.

For transfers in excess of the limits above, there is an 18%-40% tax depending upon the amount of the transfer.  You can defer the tax on a transfers to a spouse by setting up a Qualified Domestic Trust (QDOT).

Additionally, the rules are very complicated because some assets are taxed on death or gift and some assets are not.  The general rule is that if something can be considered a U.S. Situs asset, it is subject to the US Federal Estate Tax when the owner dies.  Examples of U.S. Situs assets include: real estate located in the U.S., cash or jewelry in the U.S., ownership in a US based REIT, and ownership of a US based Annuity.  Examples of Non-U.S. Situs assets include: real estate in foreign countries and stock in foreign corporations.  Less obviously, this also includes life insurance and debt obligations (such as bonds).

This is further confused by the fact that some assets considered non-U.S. situs for gift tax purposes differ from the assets that are non-U.S. situs for estate tax purposes.  Specifically, intangible property such as stock in a U.S. corporation or an interest in a US partnership or limited liability company are considered U.S. Situs assets for the estate tax, but not the gift tax. Additionally, cash on deposit in a checking or savings account at a U.S. Banking institution is a U.S. situs asset for gift tax purposes, but not for estate tax purposes.

To restate this another way, a gift in excess of $14,000 of cash on deposit in a U.S. bank is subject to a gift tax.   However, regardless how much cash is there when you pass away, it is not subject to the U.S. Estate tax.  Conversely, a gift of U.S. stock (regardless of how much), is not subject to the U.S. Gift Tax, but if you die owning the stock, anything in excess of $60,000 is subject to the estate tax.

(NOTE: a person must be really careful of that cash in a money market account is treated as an intangible asset so it is considered a U.S. Situs asset for estate tax purposes, but not gift tax purposes.) Please see this link to the IRS website which details assets that are subject to the US estate tax and those which are exempt.

If you are a non-resident, non US citizen who owns stock and real estate in the United States, your options include:
1) Paying the estate tax on your death;
2) Setting up a foreign corporation to own a local business entity (this will cause more income taxes now though, but save money on estate/gift taxes);
3) Sell the stock and property before you die and put the money into non-US situs assets until afterwards (this can be tough to time though).
4) Transfer the house to an LLC and then transfer the stock and the LLC to your children or to a trust for your children. As long as you survive for 3 years after the transfer, this should not be an issue for estate tax purposes.
5) Sell the assets and invest the money inside of a life insurance policy. That will be free of income tax and estate tax. The question is whether you can find someone to write the policy on a non-resident.

I generally recommend that if a person can afford it, you establish a US based trust in a state that doesn't have an income tax (like Florida) to own assets. Ideally you should transfer money into the trust from a non-US bank account. If you do not need the income from the trust, you can make the trust strictly for the benefit of your heirs. This will avoid an estate tax on the assets owned by the trust REGARDLESS OF WHAT ASSETS ARE NOW IN THE TRUST. This is how you can invest in the market or in real estate without worrying about an estate tax. As mentioned above trust will also help with administration and managing the funds by avoiding probate.

Remember a gift or transfer of assets may require the need to file an informational return with the IRS.  Also, the United States has tax treaties with several countries which may affect your need to do planning, so please confer with a competent international estate planning attorney before buying any assets in America.

Japanese Inheritance Tax vs. US Estate Tax (2014 Update)

BRIEF OVERVIEW OF
JAPANESE INHERITANCE AND GIFT TAXES
vs.
AMERICAN ESTATE AND GIFT TAXES

(2014 Update)

I. Estate Taxes

A. America

1. If the Decedent is a Citizen or Permanent Resident

a. Tax on Worldwide property (credit for taxes paid to foreign countries)

b. Exemption of $5,340,000 in 2014 (indexed for inflation). For married couples, the exemption amount is $10,680,000 as a result of portability.

c. Federal Estate Tax of 40% on amount over $5,340,000

d. Unlimited Marital Deduction for Surviving Spouse if Surviving Spouse is a citizen

2. If the Decedent is a Non-Citizen/Non-Permanent Resident

a. Tax only on Real Property and business interests in the United States (Cash in foreign banks and foreign stocks are not taxed)

b. Exemption of $60,000 for US based Assets

c. Tax of between 18%-40% on amount over $60,000

d. Unlimited Marital deduction if Surviving Spouse a citizen
e. Tax on bequest to surviving spouse can be delayed by creating a Qualified Domestic Trust

3. If the Decedent is not a United States Citizen or permanent resident alien, assets outside of the US can pass to a US person with no US estate tax.

B. Japan (Actually an Inheritance tax, not an estate tax)

1. Japanese Citizens and Permanent Residents

a. Tax on Worldwide property (credit for taxes paid to foreign countries) - [NOTE - this is new for 2013, previously Japan did not tax worldwide assets] 
b.  Exemption of ¥30,000,000 + (¥6,000,000 for each statutory heir); Possible additional exemption for insurance money, retirement savings, and money left to handicapped individuals [NOTE - this is a reduction from the previous exemption of ¥50,000,000 and ¥10,000,000 per statutory heir.]

c. Additional exemption for life insurance received of ¥5,000,000 multiplied by the number of statutory heirs

c. Until December 31, the highest tax rate is 50%.  Effective January 1, 2015, tax between 10%-55% for statutory heirs (spouse, children and parents) after you go over the exemption amount;

• Up to ¥10 million 10%
• Above ¥10 million up to ¥30 million 15%
• Above ¥30 million up to ¥50 million 20%
• Above ¥50 million up to ¥100 million 30%
• Above ¥100 million up to ¥200 million 40%
• Above ¥200 million up to ¥300 million 45%
• Above ¥300 million up to ¥600 million 50%
• Over ¥600 million 55% 

d. An additional 20% surcharge for everyone other else other than charities (this does include a surcharge on gifts to grandchildren);

e. For property outside of Japan, a beneficiary that acquires property will be subject to Japanese inheritance tax. (THIS IS A MAJOR CHANGE, prior to April 1, 2013, Japan did not tax gifts or inheritance of property outside of Japan received by non-Japanese nationals.)

f. A surviving spouse is entitled to a tax deduction. This is a complex formula based upon who is living at the time of the Decedent's death and where the money goes. Generally, a surviving spouse can deduct about 1/2 to 2/3 of the tax.

2. Non-Citizens/Non-Permanent Residents

a. If beneficiary is not Japanese and not living in Japan and property is not in Japan, appears Country where property located will tax such property.
b. I'm currently double checking to see if the Beneficiary is a Japanese Domiciliary whether Japan CAN tax inheritance regardless of where Decedent lived and regardless of where assets are located (subject to tax treaties)

c. If there is a tax, it appears a surviving spouse is entitled to the same marital tax deduction as for Japanese citizens.

3. Real estate acquisition tax is exempt if passing by bequest.  There is a registration and license tax at the rate of 0.4% of the assessed value of the land and building. (currently reduced?)

II. Gift Taxes

A. America

1. Citizens and Permanent Residents

a. Tax on all gift transfers of Worldwide property

b. Annual exemption of $14,000 per person/per donee (unlimited gifts for donees if different donors)

c. An annual gift to a non-citizen, permanent resident spouse, of $145,000 is available.

d. Lifetime exemption of $5,340,000

e. Gifts may be split with spouse

f. Tax rate of 40% if lifetime gifts exceed $5,340,000

2. Non-Citizens/Non-Permanent Residents

a. Tax on all gift transfers of US Property (including real estate and Stocks in US companies)

b. Annual exemption of $14,000 per person/per donee (unlimited gifts for donees if different donors)

c. Annual gift tax exemption if gift to a spouse of $145,000 (Note that a person can gift more to a spouse than they can bequest to a spouse)

c. No Lifetime exemption

d. Gifts may not be split with spouse

e. Tax rate of 18%-40% if gifts exceed $14,000

B. Japan (Rates between 10%-55%)

1. Citizens and Permanent Residents of Japan

a. Tax on gifts of property Worldwide (credit for taxes paid to foreign countries) - [NOTE - this is new for 2013, previously Japan did not tax gifts worldwide assets to certain people] 

a. Annual exemption of ¥1,100,000 for each beneficiary (beneficiary taxed after this)

b. One time spouse exemption of ¥20,000,000

c. Effective January 1, 2015, tax between 10%-55% for statutory heirs (spouse, children and parents) after you go over the exemption amount;

• Up to ¥2 million 10%
• Above ¥2 million up to ¥4 million 15%
• Above ¥4 million up to ¥6 million 20%
• Above ¥6 million up to ¥10 million 30%
• Above ¥10 million up to ¥15 million 40%
• Above ¥15 million up to ¥30 million 45%
• Above ¥30 million up to ¥45 million 50%
• Over ¥45 million 55% 
• The threshold is lower for gifts to other individuals.

d. For property outside of Japan, a donee that acquires property will be subject to Japanese gift tax.  (THIS IS A MAJOR CHANGE, prior to April 1, 2013, Japan did not tax gifts or inheritance of property outside of Japan received by non-Japanese national.)

2. Non-Citizens/Non-Permanent Residents

a. Annual exemption of ¥1,100,000 for each beneficiary(unclear – enforcement is almost impossible)
b. Japan will tax donees who live in Japan.

3. Special real estate acquisition tax of 4% (currently reduced?) in addition to a registration and license tax at the rate of 2% of the assessed value of the land and building.

III. Generation Skipping Taxes (Taxes on gifts or bequests to grandchildren or lower generations)

A. America

1. Exemption of $5,340,000 (indexed for inflation)
2. Tax of 40% on rest

B. Japan

1. None

Remember, there is an estate and inheritance treaty between the United States and Japan to minimize double taxation of assets on death if you own assets in both countries or are a resident of one living in the other country

For more information on Japanese taxes, the Japanese government has a website in English with some helpful facts, but it is now very outdated. 

I am not licensed to practice in Japan, this is just my understanding of Japanese gift and inheritance tax law that I can gather from sources which are written in English.

NOTE- Major rewrite on 9/12/14 to address changes in rates and fact that assets outside of Japan are now subject to Japanese inheritance and gift tax.

Change in New York Estate Tax Law

Effective April 1, 2014, the State of New York made numerous changes to its tax law.  Most dramatically, New York is increasing its estate tax exemption amount from $1,000,000 to match the federal estate tax exemption amount.

New York's New Estate Tax Exemption Amount
Until March 31, 2015, the new estate tax amount will be $2,062,500.
From April 1, 2015-March 31, 2016, the exemption amount will be $3,125,000.
From April 1, 2016-March 31, 2017, the exemption amount will be $4,187,500.
From April 1, 2017-December 31, 2018, the exemption amount will be $5,250,000.
From January 1, 2019 on, the exemption amount will be indexed to the federal estate tax exemption amount.

However, New York has created a devastating Estate Tax "Cliff" by phasing out the benefit of the New York Exclusion Amount for estates that exceed 100% - 105% of the exclusion amount.

The practical implication of the "Cliff" is that for estates under the NY estate tax exemption amount, there will be no tax.  For estates just above the threshhold, there will be an effect tax rate of as high as 252% (Source www.jdsupra.com).  For estates above 105%, there is a flat 16% tax on all assets owned by the decedent, not just the amount above the exemption limit.

Addition of a Three Year Look Back Provision
New York has also added a three year look back provision for gifts made within three years of death.  This provision only applies for gifts made between April 1, 2014 and January 1, 2019.  The lookback will not apply if the gifts were made when the decedent wasn't a New York resident or if the gift is otherwise includible in the decedent's taxable estate.

Other Important Changes to NY Estate Tax
Other major changes made by the new law are to:
1)  repeal New York's generations skipping transfer tax; and
2)  allow a marital deduction for non-citizen spouses.

New Law Regarding Income Taxation of NY Resident Trusts
Finally, the new law aggressively pursues an income tax on trusts for the benefit of New York residents.  The bill is going after two types of trusts.  The first one being one that a wealthy New York resident sets up for his own benefit, retaining a discretionary interest in the trust.  The second one being any trust for the benefit of a New York resident.

With respect to the first type of trust, for years, wealthy individuals have set up "incomplete gift non-grantor trusts" to avoid the New York income tax.  The idea was that if you created a trust in another jurisdiction (with the assets and trustees outside of NY) then New York would not have the right to tax the income earned in that trust to the extent income was retained in the trust.

With respect to all other trusts, New York will now tax the distributions of accumulated income to New York residents.  However, the State will offer a credit to the extent a tax is paid to another jurisdiction.

Important Items That Were Considered But Not Changed
1)  New York has not adopted the concept of portability of the estate tax exemption; and
2)  New York had considered a maximum 10% tax rate, but decided to keep it at 16%.

Gifting to Parents to Save on Capital Gains Taxes

As I gaze outside at yet another major snowstorm here in Mercer County, NJ and contemplate how nice it would be if I were visiting my folks near my Boca Raton, Florida office, I am reminded of a tax savings idea that I heard was gaining traction amongst wealthy children whose parents are still living.

With the federal estate tax exemption up to $5,340,000 after its most recent adjustment for inflation, children that own highly appreciated assets (such as stock or real estate) can simply gift these assets to their parents now. When the parent passes away, the children can receive these assets back with a stepped up basis, potentially saving hundred of thousands of dollars in capital gains taxes when the assets are finally sold.

While at first blush this seems like an incredibly easy strategy to save money on taxes, there are actually many pitfalls. In particular, the strategy will not work well if:
1) the parent is receiving Medicaid or government benefits;
2) the parent lives in a state or jurisdiction that has a state estate tax or inheritance tax;
3) the parent has remarried; 
4) the parent has significant wealth and has their own estate tax problems; or
5) MOST IMPORTANTLY, the gift must be made to the parents at least one year prior to the parent's death to avoid triggering Section 1014(e) of the Internal Revenue Code.*

Additionally, there could be problems if you have siblings or step siblings as the child who originally owned the assets would obviously want to ensure their return. Here is the final catch, the IRS will not like it if you prearrange this plan. In other words, the parent can't immediately promise/guarantee that they will redirect the asset to the child.

Finally, gifts of certain assets will require an appraisal for the federal gift tax return that would be required (Form 709), potentially making this a costly transaction.

Please contact our attorneys if you would like to learn more about this type of gift planning or any other estate planning.

*Updated on 5/22/14 to reflect the need to make the gift at least one year prior to parent's death.

Same Sex Couples Entitled to Unlimited Marital Deduction

In a landmark Supreme Court case today, United States v. Windsor, the Supreme Court ruled that the Defense of Marriage Act ("DOMA") was unconstitutional.  DOMA was signed into law in 1996 and defined marriage as between a man and a woman for purposes of federal law.  Importantly, this meant that same sex couples could not file joint tax returns and that a surviving same sex spouse was not entitled to a marital deduction (resulting in higher federal estate taxes).

As a result of this ruling, same sex couples who have married should immediately consider whether they should amend their federal tax returns for the last few years.  Consideration should also be given to whether your estate planning documents should be updated to reflect the change in the law.

The ramifications of this ruling are extremely broad, as it can affect immigration laws, the right to receive health insurance, the right to receive a pension, and Social Security.  All told, there are about 1000 laws that may be affected.

Importantly, it does not require that a state allow a same sex couple to marry.  Accordingly, in states where same sex couples are not allowed to marry, they will have to travel to another jurisdiction to get married in order to receive federal benefits.  (It is still slightly unclear at this point whether the state that the couples lives in must recognize the marriage to take advantage of federal benefits - I haven't had time to read the full opinion yet.  I will point out that New York allows same sex marriages and New Jersey recognizes same sex marriages from other jurisdictions*.  Pennsylvania and Florida have both enacted laws banning such recognition.)

Just a reminder though, strictly from a tax perspective, it does not always make financial sense to get married due to the "marriage penalty".  The marriage penalty is a called a penalty because it creates a higher tax on a married couple when both spouses work.  However, if one spouse works and the other does not, it does create a substantial tax benefit. 

*See post on the Affect of United States v. Windsor on New Jersey Same Sex Couples

Probate In New Jersey - When There Is A Will

One of the questions I frequently get is: What is involved with probate in New Jersey?

In some jurisdictions, I know attorneys go out of their way to help their clients avoid the probate process by creating trusts and titling assets so that they can be transferred automatically on death.  In New Jersey, probate usually is not that costly or difficult - at least compared to places like California, New York, Pennsylvania and Florida.

Part of the reason for this is that New Jersey requires attorneys to charge a reasonable fee, and not a percentage of the estate.  Additionally, the New Jersey does not charge much for filing a Will or for any other administration fees.  Moreover, in almost every county that I've had to deal with, the local Surrogate has been tremendously helpful in trying to assist us through the process.  I know I frequently call the Mercer County Surrogate's Office, which is a wealth of information.

So, going back to what is involved, each estate is highly unique.  However, here are some good steps to take:

1)  Deal with the family and make funeral arrangements.  An executor does not have to pay for the funeral.  Whoever pays can be reimbursed by the Estate later on.

2)  Identify valuable assets and the Will and secure them for safe keeping.  (This may include searching the house and possibly even changing locks if you think that someone may access the property unlawfully.)

3)  Identify the decedent's next of kin and obtain contact information for them.  You will need this when applying to be executor.

4)  After the Original Will has been found, identify who the Executor is. If the Executor is not alive or not willing to serve, steps must be taken so that a backup can be named.  If the Original Will cannot be found, there is a process for a having a copy approved by the Court.

5)  Take the Will to the Surrogate in the County where the Decedent resided.  Be aware that no Will can be probated in New Jersey until ten (10) days have passed since the Testator has died.  An Executor can go down to the Surrogate with all the paperwork within the first ten days, but the Letters Testamentary won't be released until that time frame has expired.

6)  Once the Executor receives Letters Testamentary (also known as Short Certificates), he can transfer assets from the name of the Decedent into estate accounts for the Decedent.  New Jersey automatically puts a lien on a Decedent's bank accounts, brokerage assets and real estate when a person passes away.  Banks will only release 50% of the assets to pay bills of the estate until they receive a tax waiver from the New Jersey Division of Tax.

7)  Shortly after qualifying as Executor, you must mail out a notice of probate to all people named in the Will AND all immediate next of kin, regardless of whether they are named in the Will or not.  This can be problematic if you wish to cut an heir out or cannot locate an heir.  I would also be a good reason to create an estate plan that will avoid probate.  If a charity is named as a beneficiary, then a notice must be sent to the Attorney General's office.

8) If the Executor did not already have access to a safe deposit box, he can do so at this point. 

9)  Within eight (8) month of the Decedent's date of death, the Executor must file a New Jersey Inheritance Tax Return and pay any taxes due.  Typically an inheritance tax return must be filed if assets are transferred to someone other than a spouse, civil union partner, child, grandchild, parent or charity.  There is a 3 year lookback.

10)  Within nine (9) months of the Decedent's date of death, the Executor must file a New Jersey Estate Tax Return and pay any taxes due.  A New Jersey Estate Tax Return must be filed if the TAXABLE estate is in excess of $675,000.  Note, the taxable estate can be different from the probate estate because the taxble estate may also include life insurance, retirement benefits, and joint accounts.  If the taxable estate is above $5,000,000 (indexed for inflation), a federal estate tax return must also be filed.  (It might be advisable to file this return in most situations on the death of the first spouse to pass on the Deceased Spouses unused tax exemption.) 

11)  The Executor must arrange for income tax returns to be filed and pay any taxes due. 

12)  The house must be cleaned and potentially sold or transferred.

13)  If there is real estate located in other jurisdictions, the Executor must do an ancillary probate.

14)  Other duties could include dealing with any business interests or intellectual property rights, assisting beneficiaries with any claims they might have for life insurance or retirement benefits, investigating the validity of claims against the estate and researching the proper title to assets.

15)  The executor should prepare an accounting for the estate.  This includes what the assets of the estate are, income, expenditures and distributions.  Unless the matter is contested, an informal accounting will usually suffice.

16)  Conduct child support searches on all beneficiaries.

17)  After the tax returns are filed and the estate receives tax waivers and all bills are paid, the Executor can transfer the assets of the estate as directed in the Will.

18)  Simultaneous with the transfers from the estate, an Executor should obtain a release and refunding bond.  This acts as a waiver to release the Executor from liability and a means by which the executor can retrieve the inheritance back in the event that new bills arise for the estate.

An executor is not required to hire an attorney to help out with an estate admistration, but it can make the process much smoother. 

Same Sex Couple Entitled to Federal Estate Tax Marital Deduction?

There was a significant court decision back in June of this year regarding the rights of same sex married couples.  The New York Federal Court concluded that the surviving spouse of a same sex married couple is entitled to an unlimited marital deduction for purposes of federal estate taxes.  Windsor v. U.S., 109 AFTR 2d ¶ 2012-870 (DC N.Y. 6/6/2012)

Prior to this case being decided (and still the law for most of the rest of the country), when one same sex married partner dies leaving assets to the surviving spouse, only the estate tax exemption amount can pass free of estate taxes.  Anything over that would be subject to the federal estate tax.  For a heterosexual couple, when one partner dies, everything that passes to the surviving spouse can go tax free.  (Although there are some limitations if the surviving spouse is not a citizen.)

The Court in the Winsdor case ruled that the so called "Defense of Marriage Act" (or DOMA) effectively allows for a same sex married couple to be taxed when a traditional married couple would not.  They declared that there was no rational basis for this outcome and therefore the law violated the equal protection clause of the Constitution.  It should also be noted that the Obama administration flatly refused to support the DOMA.  The Attorney General's office usually makes an appearance to support all laws that are being challenged.

While the New York Federal Court made an important ruling, one ruling does NOT make it the law of the land.  You should note:
1)  The DOMA is still on the books and stands in the way of allowing the marital deduction for people not living in New York.
2)  The IRS will continue to challenge these rulings and it will likely go to the Supreme Court before it is finally resolved. In fact, there was an article online on CNN about this very topic today.
3)  Not all states allow same sex couples to be married, but if the couple marries in a state that allows it, the couple would then have an excellent argument to try and qualify for this important tax deduction.

While the ruling itself focused on the federal estate tax marital deduction, it can be taken much further.  Other potential benefits include the ability to roll over the surviving spouses IRA or 401(k), portability of the unified credit, the ability to file joint income tax returns and the ability to collect Social Security.

Because of the uncertainty surrounding these matters, it will always be best to pay your taxes and request a refund from the government to avoid any penalties.  When the IRS denies such payment, which they assuredly will, you will then need to make a decision as to whether you want to take further steps to get legally involved in this fight.  For those of you who don't have the inclination to spend a lot of time and money fighting, you should engage in proper estate planning for non-traditional couples.

NJ Estate Tax - Case Study $2M

In New Jersey, tax planning and estate planning can be very important.  I'd like to show you a good representation of what a plan can do for a married couple with $2,000,000 in assets.  Let's assume that the couple has $800,000 of life insurance, a house worth $400,000, retirement accounts of $200,000, brokerage assets of $350,000, and $50,000 of other miscellaneous assets.  Let's also assume that they are both citizens and they have two young children from their marriage.

Without a will, everything will go to the survivng spouse, free of tax. However, on the death of the surviving spouse, there will be NJ Estate Tax of about $100,000.  Moreover, the two children would each receive $950,000 outright at age 18 and there would be no clear guardian named.

The biggest tax mistake most people make is that they leave everything outright to the surviving spouse.  The reason that this can be a tax mistake is because New Jersey allows each person to pass on $675,000 to their children (and grandchildren) before it taxes the estate.  If you do not use this $675,000 exemption, you lose it.  So the best way to preserve this tax exemption is to avoid giving the $675,000 outright to the surviving spouse and giving it to the surviving spouse and children in a trust.  Sometimes you will hear this referred to as a Bypass Trust, a Credit Shelter Trust or even a Family Trust.

Another big tax mistake most people make is to own life insurance on their own lives.  Most people think that life insurance passes to their heirs free of tax.  This is not true.  It is not subject to income tax or inheritance tax, but it IS subject to the Federal Estate Tax and to the NJ Estate Tax.  Usually the best way to avoid an estate tax on the payout from a life insurance policy is to have an Irrevocable Life Insurance Trust (also known as an ILIT) own the policy on the life of the insured.

So, knowing all this, let's come back to our couple.  The first thing that our couple should do is move the life insurance into a life insurance trust.  (It would be even better to have the trust buy a new life insurance policy because if you transfer a policy in to an ILIT, there will not be any tax benefits for 3 years.)

The second thing our couple should do is create Wills (or revocable living trusts).  In New Jersey, with most traditional couples, on the death of the first spouse, we will typically send the first $675,000 into a Bypass Trust for the benefit of the surviving spouse and the children.  (The $675,000 is really based upon a formula to allow the maximum amount possible to go into the this trust before there is a tax.  It various by state and also by the tax law at the time of the death of the first spouse.)  

If the first spouse to die owns more than $675,000, than that can either go outright to the surviving spouse or in a Marital Trust.  This is up to the couple to decide based upon how much they want to protect this money from creditors and future spouses.  Upon the death of the surviving spouse, everything that is in the name of the surviving spouse and everything that is in the trust for the surviving spouse gets combined and sent to the children.  If the children are young, we usually recommend that it goes to them in trust until they reach a more appropriate age.

Now that we have the plan in place, we must retitle the assets so that the plan will be effective. You see, a Will that states the first $675,000 goes to a surviving spouse in trust is useless unless the first spouse to die actually owns $675,000.  In our situation above, the house is most likely owned by husband and wife jointly, meaning it goes automatically to the surviving spouse outright regardless of what the Will says. Additionally, the life insurance and retirement accounts will most likely name the the surviving spouse as beneficiary.  For most couples, retitling the assets typically means moving the life insurance into the ILIT, preparing a new deed and otherwise moving assets around between the couple.   There is usually not much you can do with the retirement accounts.

The end result of this plan is that we will have moved $800,000 into a life insurance trust, reducing the taxable estate to $1,200,000.  The balance will be divided roughly equally between the husband and wife.  On the first to die, we send as much as we can into the Bypass Trust, utilizing their NJ Estate Tax exemption.  In this scenario, on the death of the second person, we will have reduced the NJ Estate Tax from $100,000 to $0. 

Another benefit to all this planning is that it can make the estate administration much easier and less costly.  In this econcomy, it is important to make things easier especially when you own real estate.  If you owe estate or inheritance taxes at the time of your death, a tax lien automatically attaches to the property and you will not be able to sell it with a clear title until the taxes are paid. 

Updates for 2012

I've been remiss in not writing very much lately, but I do need to advise everyone that starting January 1, 2012, the federal estate tax exemption is actually going to increase from $5,000,000 to $5,120,000 due to adjustments for the cost of living. The federal estate tax rate remains constant at 35%.

Starting in 2013, unless the government acts:

1. the current estate tax exemption amounts will revert to their 2001 level, adjusted for inflation (probably giving us an exemption amount near $1,300,000);
   
   
2. the estate tax rate will return to a graduated rate, with taxes as high as 55%; and
   
   
3. we will not have portability.

Have a happy holidays and great New Year.

Deficit Reduction Package - Change in Estate Tax Exemption?

It's way too early to know if President Obama's Deficit Reduction Package will have any traction, but I did want to point out that under his proposal, the federal estate tax exemption would be reduced from the current level of $5,000,000 per person to $3,000,000 per person starting in January of 2013. Additionally, the maximum estate tax rate would go from the current rate of 35% to 45%. The changes in the estate tax exemption amounts and rates would be part of an overall package to reduce the deficit.

I am skeptical this will pass mainly because ever since the Republicans have taken over the House, President Obama and the Democrats have not been able to successfully pursue much of their agenda. It is worth noting though that the Democrats do have significant leverage with respect to this one tax because in the event the parties cannot agree on anything, after 2012 the federal estate tax will revert to pre-2001 levels. This would mean a federal estate tax exemption amount of $1,000,000 (indexed for inflation) and a maximum estate tax rate of 55%.

The Future of Estate Tax: Will “13” Prove To Be A Lucky Number?

In my blog post of November 12, 2010, I made reference to a dinner bet I made with my father as to when a decision would be made on the federal estate tax issue. (Yes, Dad, I haven't forgotten you were right and I still owe you dinner.) At that point, we were nearing the end of a year in which there was no estate tax and we were about to revert to a tax, up to 60%, on transfers at death in excess of $1,000.000.

In an 11th hour move on December 17, 2010 President Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act into law, which reinstated the federal estate tax – but with a $5 million exemption limit and a 35% tax rate - to begin again January 1, 2011 and to sunset on December 31, 2012. Additionally, the concept of portability of the estate tax exemption between spouses was introduced.

So while we achieved relative certainty for two years, January 1, 2013 now marks the unlucky date of reversion to the $1 million estate tax exemption, estate tax rates as high as 60%, and an elimination of the portability provision.

To provide longer term certainty, President Obama, in his recently proposed 2012 budget, is hoping to change the estate tax exemption to $3.5 million, the same as it was in 2009. Additionally, he is seeking to reduce the gift tax exemption and GST tax exemption to $1,000,000 with an increase in the estate and gift tax rates to 45%. The proposal includes making portability of the exemption amount between spouses permanent, for a combined exemption up to $7 million.

You can look at President Obama's approach in two ways. You consider this change as increasing the estate tax (by raising the tax rate and lowering the exemption from its current level). However, you can also consider this reducing the estate tax (by lowering the tax rate and raising the exemption from what would happen in 2013 if nothing were done.) All I hope for is an end to these constant changes. It will be lucky for everyone when we have certainty, beyond two years, on the issue of the estate tax.

I should note that uncertainty is likely to remain as I doubt Congress will agree with President Obama's plan. Republicans control the House and they are still looking for a full repeal of what they call “the Death Taxes.”
------------------------
Thank you to my paralegal, Elizabeth Carter, for help with this post.