Law Offices of James W. Mallonee, P.A.
Port Charlotte 941-206-2223
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Helping individuals & families across Florida with their legal matters since 2005

Estate and Income Tax Planning

In 2010 the Federal estate tax exclusion was increased to $5.0 million dollars per person. Even more impressive was the fact that the Federal government gave the ability of a married couple to share any unused amount of their $5.0 million dollar exclusion with their surviving spouse. The government called this “portability.” In essence, a married couple could have an aggregate Federal estate tax exclusion of $10.0 million dollars. To take advantage of the portability, the surviving spouse must complete and file a Federal form 706 or risk losing the deceased spouse’s $5.0 million dollar exclusion. In this article we’ll explore how the portable estate tax exclusions can affect you along with other tax consequences depending on the testamentary documents chosen for a persons estate planning.

When dealing with a married couple, a trust is generally constructed to provide a means of taking advantage of the maximum Federal exclusion for estate taxes while providing a means of delivering assets to a spouse via income over a period of time. A married couple might create separate trusts with each spouse’s trust funded by ½ of the family’s total assets. It is also not uncommon for each spouse to embed a by-pass trust within their trust instrument that will provide income to the surviving spouse following the death of the first spouse. The by-pass portion of the deceased spouse’s trust is normally loaded with the maximum amount of assets that would not be subject to Federal Estate Tax following the first spouse’s death. Today that number is $5.0 million dollars; however, on January 1, 2013, that number is scheduled to drop back to $1.0 million unless Congress votes otherwise. Assets not placed into the by-pass trust normally pass directly to the surviving spouse and become a part of his or her estate. The assets that flowed into the by-pass trust ordinarily transfer out to a couples descendants following the death of the surviving spouse. Lastly, the assets that funded the by-pass trust will receive a step-up in basis, but will not receive another step-up in basis at the time of the surviving spouse’s death. A step-up in basis means that the beneficiary takes the property bequeathed to them at the current fair market value or at a value determined 6 months following a testator’s death.

In the case of a Will, the rest and residue of the first spouse’s assets normally flow over to the surviving spouse. This would also occur if all of the married couple’s assets are held jointly as tenants by the entireties. Under this scenario, all of the couple’s assets will receive a step-up in basis as it passes to the lineal descendants upon the death of the surviving spouse. For purposes of Federal capital gains and income tax purposes, the realization of a step-up in basis for transferred assets to the spouse’s descendants can be quite significant.

So which is better, a traditional Trust or simple Will? Cost wise the preparation of a Will is generally less than a Trust instrument. From a potential tax standpoint an analysis is needed as to which instrument makes more sense regardless of its initial cost. To analyze the differences, let’s presume we are dealing with a married couple who are approximately 40 years of age. The couples combined assets are $2.0 million dollars and they have one child. Let’s also assume that the estate tax percentage is 35% with a capital gain tax of 20%. Let’s further presume that the Husband (H) recently died followed by the Wife’s (W) death 60 days later. Let’s lastly presume that the couple prepared separate trusts prior to their deaths with each trust containing a by-pass trust.

In such a case, the couples’ $2.0 million dollar combined assets results in $1.0 million being placed in each spouses separate trust. The outcome of their estate would typically be as follows: 1) the husbands $1.0 million dollars would flow to the by-pass trust with nothing flowing directly to the W’s estate; 2) at the death of the W, the W’s $1.0 million dollars would flow directly to the surviving child along with the H’s $1.0 million dollars held in the by-pass trust; 3) Because the total amount of the assets is less than the current $5.0 million estate tax exclusion for each spouse, no estate tax will be applied; and, 4) Because of the closeness of the deaths of each spouse, it is unlikely that the assets passing to the child will significantly increase in value such that a capital gain tax will be a factor upon the liquidation of each spouse’s assets. If the couple had Will’s prepared instead of a trust, the outcome would be the same as the trust.

However, suppose the W lives another 30 years. This makes her 70 years of age, does this change anything? The answer is yes. Let’s assume that Congress makes the current portable estate tax law permanent. At the death of the H, the W files her Federal 706 form. This means that the W will now have an estate tax exclusion of $9.0 million dollars (H’s estate valued at $1.0 million dollars leaving $4.0 million dollars to be ported over to the W’s estate giving her a total estate tax exclusion of $9.0 million at her death assuming no inflationary changes to the exemption amount).

Using the trust example, the $1.0 million dollars of the H’s estate that is poured into the by-pass trust grows to $7.0 million over the next 30 years of the W’s life. The W’s $1.0 million dollars in assets contained in her trust also grows to $7.0 million. At the W’s death, her $7.0 million dollar estate flows estate tax free to the couple’s child because the W was able to take advantage of the H’s $4.0 million unused exclusion and add it to her $5.0 million dollar exclusion which makes the W’s total estate tax exclusion equal to $9.0 million dollars at the W’s death.

But, what about the H’s $7.0 million dollar amount in the by-pass trust. Although the $7.0 million dollars flows to the couple’s child free of estate tax, it will be subject to capital gains tax when eventually sold. The couples’ child will be facing a 20% capital gains tax on $6.0 million ($1.2 million income tax due). The reason for this is that the H’s $1.0 million by-pass trust asset never became apart of the W’s gross estate. Thus, the $6.0 million dollar increase did not receive a step-up in basis when the W eventually died. Of course the capital gain tax paid is only due upon the liquidation by the child of the assets that consist of H’s estate.

Let’s now suppose the H and W elected to have Will’s prepared for them. Upon the death of the H, the assets are transferred to the W making her estate worth $2.0. This transfer can occur as a result of the assets being jointly titled or by the H’s Will. Thirty years later, the W continues to enjoy the portability of the $10.0 million applicable tax exclusion (assuming a Federal form 706 is filed with the IRS). Because none of the H’s $5.0 million exclusion amount was used, the W gets the luxury of aggregating the H and W’s full applicable exclusion amount of $10.0 million dollars. However, the assets have grown to $14 million dollars. As a result, at the W’s death her estate will be subject to an estate tax on $4.0 million dollars (or $1.4 million in taxes due at the 35% tax rate). Because all of the W’s $14.0 million dollar estate assets are part of her gross estate, it will receive a step-up in basis making the capital gains tax zero ($0.0) should the couples’ child immediately liquidate the W’s assets.

As you can see, there can be significant differences in the tax outcome of estates depending on the amount of time that passes as well as the type of testamentary document that is selected. In addition, there is no prediction on what may happen with the current portable estate tax laws which make it difficult to create long term estate plans. However, the above scenarios should be considered when thinking about the type of testamentary document you select to carry out your wishes following your death. More importantly, deciding on whether to elect to take advantage of the estate tax portability is also crucial to your long term estate plans; especially if one of the spouses were to consider re-marrying in which case the re-married spouse may lose the aggregate estate tax from their prior spouse.

Obviously you have choices and planning for those choices are paramount to reducing the possibility of being subject to government taxation following your death. So which testamentary document is better for purposes of minimizing tax obligations? It depends on many factors that need to be discussed with an attorney or financial planner. As a result, if you are concerned about the long term effects of taxation on your estate, consult with an attorney of your choice to discuss what testamentary document will be in your best interest in minimizing your estates exposure to taxes. It could be the best consult investment you make.

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