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PERSONAL FINANCE

Estate and Gift Tax FAQ

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Will my estate have to pay taxes after I die?

It depends. The federal government imposes estate tax at your death only if your property is worth more than a certain amount - $650,000 to $1 million, depending on the year of death. But there are a couple of important exceptions to the general rule. All property left to a spouse is exempt from the tax, as long as the spouse is a U.S. citizen. And estate tax won't be assessed on any property you leave to a tax-exempt charity.

Year of Death Exempt Amount
1999 $650,000
2000, 2001 $675,000
2002, 2003 $700,000
2004 $850,000
2005 $950,000
2006 and after $1 million

Important new rules also apply to family-owned businesses and farms, which may receive a special $1.3 million exclusion from estate tax. This amount is not in addition to the amount listed above, which is available to everyone. For example, if when you die the general exempt amount is $700,000, then a business that qualified for the increased exemption would get another $600,000 exemption, for a total of $1.3 million.

To qualify for this special increased exemption, the business must meet several rules:

  • It must constitute more than 50% of your estate.
  • Its principal place of business must be in the United States.
  • You must meet IRS participation requirements in the business before your death.
  • You must leave your interest in the business to family members or people who have been actively employed by the business for at least 10 years before your death. (More rules apply if you leave the business to non-U.S. citizens.)

If the people who inherit the business stop participating in the business for at least five of any eight-year period within the 10 years following your death, they will have to pay back some of the tax that was avoided at your death.

These rules are complex and untested. Consult an estate planning specialist if you have questions.

What are the rates for federal estate taxes?

The rates are steep, starting at 37%. The maximum is 55% for property worth over $3 million.

Are there ways to avoid federal estate tax?

Yes, although there are fewer ways than many people think, or hope, there are.

The most popular method is frequently used by married couples with grown children. It's called an AB trust, though it's sometimes known as a " credit shelter trust," " exemption trust," " marital life estate trust," or " marital bypass trust." Spouses put their property in the trust, and then, when one spouse dies, his or her half of the property goes to the children - with the crucial condition that the surviving spouse gets the right to use it for life and is entitled to any income it generates. When the second spouse dies, the property goes to the children outright. Using this kind of trust keeps the second spouse's taxable estate half the size it would be if the property were left entirely to the spouse, which means that estate tax may be avoided altogether.

Unlike a probate-avoidance revocable living trust, an AB trust controls what happens to property for years after the first spouse's death. A couple who makes one must be sure that the surviving spouse will be financially and emotionally comfortable receiving only the income from the money or property placed in trust, with the children as the actual owners of the property.

How an AB Trust Works: An Example
Ellen and Jack have been married for nearly 50 years. They have one grown son, Robert, who is 39. Ellen and Jack create an AB trust and transfer all their major items of property to it. They name each other as life beneficiaries, and Robert as the final beneficiary.

Ellen dies first. The trust automatically splits into two parts. Trust A, which is irrevocable, contains Ellen's share of the property. Trust B is Jack's trust, and it stays revocable as long as he is alive.

The property in Trust A legally belongs to Robert, but with one very important condition: his father, Jack, is entitled to use the property, and collect any income it generates, for the rest of his life. When Jack dies, the property will go to Robert free and clear.

Now let's take a look at the tax savings:

Ellen's half of the trust property is worth $500,000 when she dies.

At Ellen's death, in 2000

Taxable estate $500,000
Estate tax $0 (because $675,000 can pass free of tax in 2000)

At Jack's death, in 2004

Taxable estate $500,000
Estate tax $0

If Ellen had left all her property to Jack outright, his estate would have been worth $1 million, $150,000 of which would have been taxed.

Another way to save on estate taxes is to use what's called a " QTIP" trust. It enables a surviving spouse to postpone estate taxes that would otherwise be due when the first spouse dies. And there are many different types of charitable trusts, which involve making a sizable gift to a tax-exempt charity. Some of them provide both income tax and estate tax advantages.

Can't I just give all my property away before I die and avoid estate tax?

No. The government long anticipated this one. If you give away more than $10,000 per year to any one person or non-charitable institution, you are assessed federal " gift tax," which applies at the same rate as the estate tax.

Making gifts of less than $10,000, however, can yield substantial estate tax savings. If you give away $10,000 for four years, you've removed $40,000 from your taxable estate. And each member of a couple has a separate $10,000 exclusion. So a couple can give $20,000 a year to a child free of gift tax. If you have a few children, or other people you want to make gifts to (such as your sons- or daughters-in-law), you can use this method to significantly reduce the size of your taxable estate over a few years. (The $10,000 amount is now indexed for inflation, and will increase in $1,000 increments in years to come.)

Consider a couple with combined assets worth $1 million and three children. Each year they give each child $20,000 tax free, for a total of $60,000 per year. In seven years, the couple has given away $420,000 and has reduced their estate to $580,000, below the federal estate tax threshold.

Of course, there are risks with this kind of gift-giving program. The most obvious is that you are legally transferring your wealth. Gift giving to reduce eventual estate taxes must be carefully evaluated to see if you can comfortably afford to give away your property during your lifetime.

Some other kinds of gifts are exempt from the gift/estate tax as well. You can give an unlimited amount of property to your spouse, unless your spouse is not a U.S. citizen, in which case you can give away up to $101,000 per year free of gift tax. Any property given to a tax-exempt charity avoids federal gift taxes. And money spent directly for someone's medical bills or school tuition is exempt as well.

Do some states impose death taxes?

A handful of states impose death taxes. These taxes are of two types: inheritance taxes and estate taxes.

Inheritance taxes are paid by your inheritors, not your estate. Typically, how much they pay depends on their relationship to you. For example, Nebraska imposes a 15% tax if you leave $25,000 to a friend, but only 1% if you leave the money to your child. These rates vary from state to state.

States That Impose Inheritance Taxes
Connecticut (will be phased out by 2005) Louisiana New Jersey
Delaware Maryland North Carolina
Indiana Michigan Pennsylvania
Iowa Montana South Dakota
Kansas Nebraska Tennessee
Kentucky New Hampshire

State estate taxes are similar to the estate tax imposed by the federal government. Your estate must pay this tax no matter who your beneficiaries are. The good news is that every state except Mississippi, New York, North Carolina, Ohio, and Oklahoma has abolished these taxes, at least in effect. (New York is phasing out its tax.) In the rest, the state takes part of the money that you owe to the feds; it's a matter for accountants and tax preparers, but doesn't increase the tax bill.

Can I avoid paying state death taxes?

If your state imposes death taxes, there probably isn't much you can do. But if you live in two states - winter here, summer there - your inheritors may save on death taxes if you can make your legal residence in the state with lower, or no, death taxes.

Copyright © 1999 Nolo.com Inc.

Last updated: Oct 21, 1999




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