Financial success carries great benefits, but it can present a challenge as well. The federal estate tax looms large for high net worth individuals because it carries a 40 percent top rate.
A certain amount may be transferred tax-free upon your death through a credit or exclusion. Currently, the exclusion is $11.7 million, so it does not impact most Americans today. However, by law, the exclusion will drop to $5 million in 2026, and Congress could make additional changes at any time.
You have to take steps to gain estate tax efficiency if the value of your estate is in taxable territory. We will provide some food for thought in this post.
The estate tax was originally enacted in 1916. However, no gift tax was established at that time. It is not hard to guess what people did to avoid the tax: they simply gave gifts to their loved ones while they were still living.
A gift tax was enacted in 1924 to close the loophole, but it was repealed two years later. In 1932, the gift tax was reenacted, and has been in place since then. The gift tax and the estate tax are unified under the tax code, so the exclusion applies to lifetime gifts and your estate.
However, there is a separate gift tax exclusion that can be used to give as much $15,000 to any number of gift recipients on an annual basis tax-free. This may not sound like a lot of money to someone that is exposed the estate tax, but the gifts can add up.
Let’s say that you are married and you have three married children. You and your spouse could combine your respective exclusions to give $30,000 to any number of individuals. This is called the practice of “gift splitting” in estate planning and tax parlance.
Since you have three married children, you could give $30,000 to each husband and wife every year. This would enable you to transfer $180,000 tax-free annually, and if you do this for an extended period of time, the numbers will add up.
In addition to the fact that these are tax-free transfers, these transfers also reduce the taxable value of your estate. This approach can apply to direct gift giving, as well as transfers to members of a family limited partnership.
There are a number of different types of irrevocable trusts that are used for estate tax efficiency purposes, and one of them is the qualified personal residence trust (QPRT). To implement this strategy, you fund the trust with your home, and you name a beneficiary.
When you create the trust, you establish a period of time during which you will live in the home rent-free. This interim is sometimes referred to as the retained income period.
You name a beneficiary that will inherit the property after you pass away. As soon as you fund the trust with your home, it is no longer part of your estate for tax purposes, but the transfer to the beneficiary at the end of the retained income period will constitute a taxable gift.
When the IRS calculates the value of the gift, it will be considerably less than the fair market value because you will not be relinquishing control of the property for a number of years. Ultimately, the transfer will take place at a significant tax discount.
This is just one of the trusts that can be used to mitigate your estate tax exposure. Others include the grantor retained annuity trust, the generation-skipping trust, the charitable remainder trust, and the irrevocable life insurance trust. We will look at those trusts in future blog posts.
Unlimited Marital Deduction and the QDOT
In closing, we should point out the fact that there is an unlimited marital deduction. You can transfer unlimited assets to your spouse tax-free as long as your spouse is an American citizen.
If you are married to someone that is a citizen of another country, you could use a qualified domestic trust to delay the imposition of the estate tax until the passing of your spouse. This is another device that we will examine at another time.
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We are here to help if you are ready to work with an Oklahoma City estate planning lawyer to put a plan in place. You can send us a message to request a consultation appointment, and we can be reached by phone at 405-843-6100.