California Estate Planning – Federal Estate Tax

INTRODUCTION TO ESTATE TAXES

by: John B. Palley, Attorney

There has been a lot of talk in the news about “estate planning” and “estate taxes,” the last couple of years but what do these terms really mean? Sitting at the local coffee shop, you may hear people discussing the “living trust” they set just set up, and how it will avoid estate taxes. At the golf course you may over hear a conversation about which is the best way to title your house, in joint tenancy, or in some other fashion. I will attempt here, and throughout my website, to explain estate planning, estate taxes, and how they inter-relate to each other. This article is focused on California law as I am a California estate planning attorney. In fact, I am a certified specialist in estate planning, trust and probate law which means I took a second bar exam only in these areas of law.

What is “estate planning”?

Estate planning is the process of arranging one’s property and estate to gain maximum benefit of all laws while carrying out the person’s own wishes for the disposition of his property upon his death. The laws of wills, taxes, insurance, property and trusts are all involved in an overlapping fashion. There are many good reasons why you should establish an estate plan, among them: you can decide who receives your assets, you decide how and when your beneficiaries will receive their inheritance, you decide who will manage your estate, you can reduce taxes and administrative expenses, you select a guardian for you child, you can provide for your health care and financial needs should you become incapacitated, and you can provide for the orderly continuance or sale of a family business. In this article, I will focus on the cost of estate, gift and other taxes.  In other articles I talk about the high cost of probate which is like a tax.

How do estate taxes work?

Estate taxes can take a big chunk out of your estate. I have been practicing law since 1994 and I have seen huge changes during those years.  As I write this article there is a fair amount of uncertainty so make sure you check with me or your own estate planning attorney to make sure things are current.  As of today (September 2011) estate taxes start at 18% and quickly move to 35%. Not that along ago the top rate was 55% and, in fact, the way the law is written today on January 1, 2013 the law will go back to 55%.  That’s right over HALF of your assets can pass to the government, rather than to your heirs! Although this can lead to some people feeling they may lose the incentive to build more wealth, there are ways to reduce, and in many cases completely avoids this tax.

Each individual who is a US Citizen can give away up to $5,000,000 during their life or at death without paying tax as of today.  The way the law is written today it will go back down to $1,000,000 on January 1, 2013 and thus we often use that $1,000,000 threshold in our estate planning work. This number called the unified credit or exemption amount. It is “unified” because gift taxes (gifts during life) and estate taxes (gifts at death) work together in a single (or unified) tax table. Additionally each person in our country can give away $13,000 each year to every single person they want to, without a tax consequence.

Let’s assume the $1,000,000 exemption is in play at your death; that is, you are not planning to die before January 1, 2013.  This may quickly lead you to believe that you and your spouse together can give away $2,000,000 at death without worrying about paying taxes? However, this is not exactly the case. Let’s take the hypothetical husband and wife with $1,300,000 in total assets. If the husband dies he likely will leave everything to his wife. He does not get to utilize his $1,000,000 unified credit because in the US we have an unlimited marital deduction. This means gifts between spouses, either during life or at death, can be in unlimited amounts. When the wife dies she has an estate of $1,300,000 and only her $1,000,000 unified credit to use. Thus $300,000 is taxed at her death, at a marginal rate of 35% (or 55% after January 1, 2013).

This tragedy can be avoided, however. To do this, you must set up a special kind of trust, called an “A/B” or “By-Pass” Trust. The By-Pass Trust works to allow you and your spouse to pass up to $2,000,000 in assets without worrying about estate taxes. The way it works is to put up to $1,000,000 into the By-Pass Trust at the first death (or $650,000 in the above hypothetical). The surviving spouse gets the income from the By-Pass Trust, and can invade the principal for certain reasons. This trust utilizes the unified credit of the first spouse to die, and thus maximizes the money passing to your heirs. In the case of a couple able to utilize the entire $2,000,000, you pass approximately an additional $300,000 to your heirs!

Other Taxes

In addition to the above there are many other tools available as a person’s estate gets larger which can help to reduce taxes and thus pass more money on to your heirs. Among them, the popular ones are Irrevocable Life Insurance Trusts, Family Limited Partnerships, Charitable Remainder Trusts, Generation Skipping Trusts, Q-tip Trusts, Q-DOT Trusts, House GRITs, GRATs, and GRUTs. These will be discussed in more detail in the following pages.

More Advanced Estate Planning Tools

In addition to the above there are many other tools available as a person’s estate gets larger which can help to reduce taxes and thus pass more money on to your heirs. Among them, the popular ones are Irrevocable Life Insurance Trusts (ILITs), Family Limited Partnerships (FLPs or “Flips”) or Family Limited Liability Companies (FLLC’s), Charitable Remainder Trusts (CRTs), Generation Skipping Trusts (GST’s), dynasty trusts, Qualified Terminable Interest Property Trusts (Q-tip Trusts), Qualified Domestic Trust for non citizen spouses (Q-DOT Trusts), Qualified Personal Residence Trusts (QPRTs), GRATs, GRUTs and on we go with acronyms. These will be discussed in more detail on other pages of this website.

What does this all mean to you?

Every person, no matter how large or small their estate, should do some estate planning. Very few people need no estate plan. Many people say they do not have sufficient assets to justify putting together a full estate plan. However, have they thought about who will take care of their children if they are to die prematurely without a will?

Many people have a modest amount of assets, but do not feel they have enough to worry about a full estate plan. Probate can take a big chunk (8% or more) out of anybody’s estate, once they get toward the area of $100,000 in gross assets. In which case, a revocable trust may be right for them.

As people get up to the half million dollars and upwards range, they have to start thinking about By-Pass Trusts, Q-tip trusts and possibly start thinking about how their life insurance is held. The possibilities increase from here as the size of the estate increases. The point is, that everybody needs to do some planning, to maximize the amount of their hard earned wealth that passes on as they desire and not to the government.

Ratings and Reviews