Federal Estate Tax
· Am I required by the laws of my state to leave a portion of my assets to my spouse?
The inheritance and succession statutes of most states contain a provision designed to prevent a spouse from being disinherited. Such statutory provisions, often called elective-share statutes, entitle a surviving spouse to a minimum distribution from the estate of a deceased spouse and can be used to override the terms of a trust or will. If you do not take this into consideration when designing an estate plan, the enforcement by your spouse of his or her elective share can significantly disrupt the settlement of your estate.
· How do I determine whether I have given my spouse at least as much as the elective-share amount if I have provided for my spouse with lifetime interests in one or more trusts?
The answer to this question is a matter of state law about which you should contact an estate planning attorney in your state. However, assuming your state has an elective-share statute, your state code will generally have “commutation rules” which provide a means of valuing a spouse’s lifetime interests in the marital trust and any other lifetime trust created for the benefit of a spouse.
Once you have calculated that amount, you can compare it to the elective-share amount to determine whether your spouse would be entitled to an elective-share of your estate.
· If I wish to leave assets to my spouse, is there a preferred way to do so?
One of the best ways to leave assets to a spouse is through a revocable living trust. Following are some of the advantages of using revocable living trust planning:
· Probate can be avoided on the deaths of both spouses.
· A living probate can be avoided if the surviving spouse is unable to manage his or her financial affairs after the first spouse dies.
· Federal estate tax may be eliminated on the first spouse’s death and either eliminated or substantially reduced on the death of the surviving spouse, depending on the size of the estate.
· A trustee can be named to serve with the surviving spouse and provide him or her with asset and financial management assistance.
· By leaving assets in trust, you may provide your spouse with creditor protection if the spouse is sued.
· The assets left in trust can be protected from a later, unsuccessful second marriage of your spouse. Additionally, your surviving spouse may be able to more comfortably refuse to give away assets or to loan money to other family members or friends by stating that the assets were left in trust and cannot be used for those purposes.
· How much property can I leave to my spouse without incurring federal estate taxes?
You can leave an unlimited amount to your spouse without paying any federal estate taxes. Every dollar you leave to your spouse qualifies for the marital deduction, which offsets, dollar for dollar, the assets included in your gross estate. Since your gross estate minus your allowable deductions is your taxable estate—the amount on which taxes are paid—the marital deduction can effectively reduce your taxable estate to zero.
Generally the tax law allows use of the marital deduction to cancel the estate taxes on the first spouse’s death, but there is a catch: Those assets which qualify for the marital deduction in the first spouse’s estate will be taxable in the estate of the surviving spouse, without the benefit of a marital deduction (unless the surviving spouse has remarried).
If you leave all of your property to your spouse, your estate will not pay any estate taxes if your spouse survives you; but upon your spouse’s death, the entire value of your property plus your spouse’s property will be subject to estate taxes.
· What about a family trust? What rights must be given to a spouse?
There is no requirement that a spouse be given any rights in a family trust. In fact, a family trust is designed so that it will be subject to estate tax at the maker’s death and will not be included in the surviving spouse’s estate upon his or her death. Remember, this trust’s assets are sheltered from tax by the applicable exclusion amount, so even though the family trust is estate-taxable at the first spouse’s death, there is no estate tax liability.
Typically, a spouse is given rights to the income and principal in a family trust. It is not uncommon for a spouse to have the absolute right to income in the family trust and the right to use the principal under certain circumstances. The family trust can be drafted liberally to allow a great deal of spousal rights, although the surviving spouse cannot have unrestricted access to the principal or the trust will be included in his or her estate. The terms of a family trust are drafted by your attorney after he or she fully understands your financial situation and your planning goals.
· As the value of the family trust grows, will any increase over the initial applicable exclusion amount be subject to estate tax at my spouse’s death?
The family trust is designed to be tax-free when the first spouse dies. The value of the family trust is equal to the applicable exclusion amount, meaning that no tax is due. If the family trust is properly drafted and administered, it is not included in the estate of the second spouse to die, regardless of how much it has grown.
· How important is the fact that the family trust, no matter how large it grows, will not be subject to estate tax when the surviving spouse dies?
The family trust’s tax-free benefit can be significant. A simple approximation of the value of the family trust in the future can be calculated using the Rule of 72. This rule states that if you divide 72 by the interest rate or rate of growth of an asset, the result is the number of years it takes to double that asset. For example, 72 divided by 7.2 equals 10; that is, it takes 10 years to double the asset at 7.2 percent growth. The recent equities market has produced returns in excess of 14.4 percent, which, when divided into 72, results in 5; it takes 5 years to double an asset at 14.4 percent growth. Minimal inflation of 3.6 percent divided into 72 equals 20, so it takes 20 years to double an asset at the inflation rate. If we apply the growth rate of 7.2 percent to the family trust and assume that your spouse will survive you by 20 years, the value of the family trust will double twice. The entire family trust will pass to your children free of federal estate tax, no matter how large it has grown.
· What is the best possible way to protect my estate for my children, provide for my spouse, and defer federal estate tax?
The best approach is to create a qualified terminable interest property (QTIP) trust in your living trust document. A QTIP is a type of marital trust that qualifies for the unlimited marital deduction. After you are deceased, all or part of your assets passes to the QTIP trust. Your spouse is the only beneficiary of the QTIP trust, and the trust continues for his or her lifetime. Upon your spouse’s death, the remaining trust assets pass to your children according to the terms of your trust. QTIP trusts are discussed in detail in Chapter 6.
· What are the maximum rights my spouse can have in my family trust?
The maximum rights a spouse can be given in a family trust without having the value of the trust included (and thus taxed) in his or her estate are the rights to:
· Receive all the income
· Receive the greater of 5 percent or $5000 of the trust’s principal each year
· Receive any or all of the principal in the trustee’s discretion
· Appoint the property, through a limited testamentary power, to any recipient other than the spouse’s estate or the creditors of his or her estate
If you were to grant your spouse greater rights than these in the family trust, your spouse would be deemed to control the assets and, at his or her death, the full value of the trust property would be included in his or her estate for tax purposes—the very outcome you sought to avoid by using the family trust.
· What are the minimum rights I can give my spouse in my family trust?
If your spouse either consents to give up his or her rights or receives property of yours at your death that suffices to comply with your state’s rules, your family trust does not have to provide for your spouse.
· Will there be an income tax on the family trust’s income?
Yes, the income earned on the assets in the family trust will generate an income tax, which must be paid by the trust if the income is retained in the trust. If the income is distributed to the surviving spouse or to the children, they must report and pay income tax on the trust income at their respective tax brackets. The trust receives a deduction for the amounts distributed so that the trust income is taxed only once.
· Do the assets in the family trust receive a stepped-up basis upon the death of either spouse?
On the death of the first spouse, the assets in a family trust receive a step-up in basis because they are included in the deceased spouse’s estate. However, upon the death of the surviving spouse, the assets distributed from the family trust do not receive a stepped-up basis. Since assets held in the family trust are not included in the surviving spouse’s estate (they pass to the beneficiaries of the family trust free of estate tax), they do not receive a step-up in basis at the death of the surviving spouse.
· Since the assets in the family trust do not receive a stepped-up basis upon the death of the surviving spouse, would we be better off to forgo the use of the family trust altogether?
You would not be better off if, on the death of the second of you to die, there is a federal estate tax due. The federal estate tax rates range from 37 to 55 percent (60 percent on estates between $10,000,000 and $21,040,000). The federal income tax rates on capital gains are considerably less at 20 percent for most assets, and they apply only to the excess of the money received for the asset over its tax basis. Even considering state income tax on capital gains, which can increase capital gain taxes by as much as 8 percent in some states, in a taxable estate you will always be better off passing property by using your applicable exclusion amount than you would be if you retained the property in the survivor’s estate in order to obtain a step-up in basis at the time of the second death.
· My spouse and I are having revocable living trusts drafted, and we are discussing the division of our assets between the two trusts. I am concerned about taking assets that were titled to me and transferring them to my spouse’s trust. In the event of a divorce, do I retain the assets that were in my name prior to the transfer to my spouse’s trust?
In most states, during a divorce proceeding, property is divided into either “marital property,” which is subject to “equitable distribution” by the court, or “nonmarital property,” which is not subject to equitable distribution. Generally, the manner in which assets are titled does not affect their classification as either marital or nonmarital property: the court will categorize the assets under the state’s guidelines and will distribute property without regard to whose name appears on the title. Thus, whose living trust holds title to which assets is of little consequence in a divorce proceeding.
· My spouse and I have an estate over $650,000. Rather than doing a trust now, can we wait until one of us dies and set up a trust at that time?
Your question assumes that when you or your spouse dies, the survivor will have the capacity to create a trust; this may not be the case. It also assumes that you and your spouse will not die simultaneously; this, too, may not be the case. Both of these possibilities should be considered in your planning.
In addition, one of the purposes of a living trust is to preserve both spouse’s applicable exclusion amounts (so that both can pass the maximum amount estate tax—free to their heirs). Since your applicable exclusion amount belongs to you, and not to your spouse, you are the only person who can make the arrangements under your estate plan to use it. In other words, your applicable exclusion amount is not an election that your spouse can make after your death. While your spouse can set up a living trust after your death, your spouse will be limited to his or her own applicable exclusion amount. Therefore, you and your spouse should establish and fund your separate revocable living trusts or joint trust while both of you are living.
· I want to make sure that the money I made during my life goes to my children and not to someone my husband marries after I’m gone. What can I do to prevent that?
You can have your attorney add a clause to your trust which, in the event of remarriage, shuts off access to the income or principal, or both, of the family trust and to the principal of the marital trust. (Remember, your husband must be able to receive all the income from the marital trust for his life in order to qualify that trust for the marital deduction.) You can also provide that if your husband’s marriage ends for any reason, he can once again benefit from the provisions that were terminated at the time of the remarriage.
When you use this provision, it is important that the trustee of the living trust be someone other than your husband or that there be a trustee serving with your husband. If your husband were the sole trustee, he could deplete the marital and family trusts before the children knew about the remarriage provision. The children would then be at the point of having to sue your husband or possibly lose the funds.
· My husband and I do not have a good marriage; we are staying married for the benefit of the children. Although we live in a community property state, I have quite a bit of separate rental real estate property. If something happens to me, I want to make sure the children are provided for. Can I do that?
Yes. You can leave all your separate property in trust, with the income to benefit your children. In order to ensure that your wishes are followed, and because you may not feel comfortable with your husband as the trustee, you may want to name a corporate trustee, such as a bank trust department or an established trust company.
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