Death taxes represent a significant estate planning problem for wealthier clients. Death taxes in the United States can be traced back to the Revolution. The current law, amended many times, goes back to 1916.
The original justification for current “estate tax” was to pay for World War I and to provide a way to break up the concentrations of wealth and family fortunes which were created during the Industrial Revolution. Around the turn of the 20th century, it was estimated that one-sixth of the world’s wealth was held by as few as 50 families.
Death taxes are divided into two types. The first type of tax is an estate tax imposed by the federal government or IRS. The second type of tax is an inheritance tax imposed by the state. Although some states do not have a death tax, Tennessee does. Arkansas and Mississippi do not. When referring to both taxes, we will call them a death tax. When referring to the federal law, the tax will be referred to as the estate tax. References solely to the Tennessee inheritance tax will be referred to as an inheritance tax.
In 2006, approximately 13,000 families actually paid federal estate tax. An estimated $28 billion in tax was paid.
What Assets are Subject to Tax?
The first question most people ask is, “What assets are subject to death tax?” The answer to the question is simple. Everything you own at the time of your death is an asset of your estate and subject to death tax. This includes real estate, stocks, bonds, bank accounts, retirement plan assets, annuities, household items and all of your assets of every nature and type. Life insurance is included as an asset of your estate unless special steps are taken to exclude the proceeds from tax through special ownership arrangements or by placing the life insurance in what is referred to as an Irrevocable Insurance Trust.
As a general rule, estate assets are taxed regardless of how they are owned. For instance, a bank account held jointly by a mother and daughter will be presumed by the government to be owned 100% by the mother at the time of her death and the entire balance in the account will be subjected to death tax unless the daughter can show that she, rather than her mother, provided the funds to create the account.
In some cases, even assets you do not own are taxed. Assets you have given away may, in some circumstances, be included in your estate. For instance, if you give property away but retain the right to use the property during your lifetime or retain the income from the property, then the entire value of the property is added back to your estate at death and taxed. Likewise, if you give property away but retain the power to control the property during your lifetime, the entire value will be added back to your estate at death.
If you transfer the ownership of a life insurance policy on your life to a trust or to a child in an effort to divest yourself of any interest in the policy, the policy proceeds will still be included in your estate if they are payable to your estate or if you transferred the policy within three years of your death.
Gifts during life having a value in excess of the gift tax limitations (presently $12,000 per donee per year) which you made during any year will be added back to your estate for the purpose of calculating the amount of estate tax due at death. All gifts made within three years of death are added back into the estate for inheritance tax purposes.
How is Property Valued?
There is a misconception that property is valued for death tax purposes at less than its fair market value. The rules for valuation of most property in an estate are very simple. It is a “willing buyer willing seller” test. In general, property is valued for death tax purposes at the value that a willing buyer would pay a willing seller, both having full knowledge of all facts and neither being under any obligation to buy or sell. Thus, the property is not valued at a forced sale price unless it is actually sold, nor is it valued at its assessed value for local real estate tax purposes unless the value actually represents fair market value.
The Marital Deduction
There are special death tax rules for a husband and wife who are U.S. citizens. Generally, property passing from one spouse to the other is not taxed. Thus, at the death of one spouse, there can be no death taxes imposed if all of the assets are distributed to the surviving spouse. This exception is not available if the spouse who inherits property is not a U.S. citizen or where the spouse’s inheritance is restricted in some way.
Distributions to a citizen spouse qualify for what is known as the Marital Deduction and receive tax free treatment if the spouse receives the assets outright and without any restrictions. Distributions to a spouse in trust require that the spouse receive all of the income and further require that no other person have any interest in the trust during the lifetime of the spouse. Provisions which cause the spouse to lose or forfeit the rights to property during life, such as a provision which results in a forfeiture in the event of a remarriage, cause the estate to lose the Marital Deduction and pay tax. Accordingly, any distribution to a spouse in a manner other than an outright distribution, free of any restrictions, should be attempted only with the advice of an estate planning expert.
Transfers to Others
Assets distributable to individuals other than a spouse or to a charity produce death tax. As a general rule, you are presently allowed to distribute $2 million free of federal estate tax to persons other than your spouse or charity. To the extent that your estate assets exceed $2 million, a good rule of thumb is to assume that 41 to 45 cents on the dollar will be paid in estate tax.
The current estate tax law provides that the amount which can pass tax free to beneficiaries other than a spouse or charity is to increase from $2 million to $3.5 million in 2009. However, proposals before Congress will likely result in the estate tax law being changed before 2010. Thus, it is possible that we will see the exemption increase or the tax rate change.
State Inheritance Tax
For residents of Tennessee, the current exemption is $1 million for distributions to individuals other than a citizen spouse or charity. For every dollar that the estate exceeds the exemption, you can assume approximately nine cents in Tennessee inheritance tax. The inheritance tax paid to the State of Tennessee is a deduction for federal estate tax purposes, thereby effectively reducing the amount due to the IRS. However, given a combined estate tax and state inheritance tax rate of 50% on all estates over $2 million, the total tax can be substantial.
Planning Techniques
Available planning techniques will not be discussed in this article. However, it is sufficient to say that the goal of most estate planning by husband and wife is to produce two separate exemptions causing up to $4 million to pass tax free under current law for estate tax purposes and up to $2 million to pass tax free for Tennessee inheritance tax purposes.
This type of planning typically involves the utilization of one or more trusts for the benefit of a surviving spouse for life. It also requires changing the structure of assets and altering beneficiary designations on life insurance or other assets.
Conclusion
Proper estate planning not only reduces taxes but also includes planning to provide the dollars to pay death taxes which cannot be avoided. Whether the taxes imposed at death are $5,000 or $5 million will make little difference if the estate does not have liquid assets available to pay the tax. Regardless, proper planning will reduce death taxes payable by your family in every case. Why would you elect to pay unnecessary death taxes when, through proper planning, those taxes can be reduced or even eliminated?
A. Stephen McDaniel
Williams, McDaniel, Wolfe & Womack, P.C.
5521 Murray Avenue
Memphis, Tennessee 38119
901-767-8200
smcdaniel@wmww.com