Understanding the Basics

The Applicable Exclusion Amount

Your estate tax situation will depend on how large your estate is when you die. The law allows you to transfer a certain amount of assets free of estate and gift tax. This amount is called the "applicable exclusion amount." In 2020 every person may transfer assets at death valued in the aggregate at $11.58 million ($11.4 million in 2019) free from estate tax. For lifetime transfers— i.e., gifts —the applicable exclusion amount is the same. The total amount used during your lifetime against your gift tax in effect reduces the credit available to use against your estate tax.
The Impact of the Portability of the Federal Estate Tax Exclusion – Example #1

Assume a husband and wife each have $11 million of exclusion available. The husband dies with $3 million of assets in his estate, which he is leaving to the couple’s children. Because the $3 million is less than the $11 million, no federal estate taxes are actually due and no return is required. However, if the husband’s estate files an estate tax return and makes the election to transfer the DSUE, the wife’s exclusion is increased by $8 million. Now the wife’s estate has $19 million available to transfer to the heirs free of federal estate tax.

You may say, ‘that all sounds great, but there is no way my spouse and I will ever have over $22.8 million.’ That may be true, but the current exclusion is scheduled to revert back to the pre-2017 amount ($5 million adjusted for inflation) on January 1, 2026. This should amount to roughly $6 million after the expected inflation adjustments. Also the exclusion has been raised and lowered by Congress many times in the past and could be scaled back again any time.

The Impact of the Portability of the Federal Estate Tax Exclusion – Example #2

Again, assume a husband and wife each have an $11 million exclusion. The couple has done no estate planning. The husband has a $3 million IRA, his wife is the beneficiary, and they hold their remaining $6 million estate jointly. He dies with a $6 million estate ($3 million IRA plus half of the joint assets), which will all pass to the surviving spouse. Since transfers to spouses are free from estate tax, the settling of the husband’s estate will not use up any of his $11 million exemption, and no federal estate tax filing is required.

The surviving spouse now has the entire $9 million of assets in her estate. Now assume that in 2021 Congress lowers the exclusion to $5 million (keeping the tax rate at the current 40%). The wife dies in 2021. Her estate will owe $1.8 million in estate taxes ($9 million less $5 million times 40%). However, if the husband’s estate had filed an estate tax return and made the election to transfer the DSUE, the wife’s exemption would be $16 million (the DSUE of $11 million plus her exemption of $5 million), and no estate tax would be due.

Other Important Considerations of the Portability Election

An added benefit of the portability election is a “relaxing,” if you will, of the diligence and complexity couples need to maintain with regard to each spouse’s estate value to ensure no exclusion is wasted. Before portability, the couple in Example #2 would most likely have established living trusts to hold their assets, and would have balanced assets between the trusts to ensure each could use up all or a large portion of the exclusion if they were to die first. They may have been able to avoid the estate tax at the death of the surviving spouse without filing an estate tax return; however, this strategy would have required legal documents, valuation monitoring, and possible transfers back and forth during lives to maintain optimal estate values for each of them on an ongoing basis. Then there would also be ongoing income tax compliance after the first death for the irrevocable trusts that would remain after the estate closing.

One final important factor to consider is that under recently finalized IRS regulations, there will be no reduction or claw back of any transferred exclusion should the basic exclusion amount be reduced sometime in the future.

Surviving spouses should seriously consider the potential advantages of filing Form 706 to make the portability election. Normally, Form 706 is due nine months from the date of death with a six-month automatic extension available. However, if the 706 is filed only to elect portability, it can be filed anytime on or before the second anniversary of decedent’s death.

The passing of a spouse is a difficult time and requires the assistance of your advisory team. Discuss the portability election with your tax team now to determine if this strategy is right for you.



The Generation-Skipping Transfer Tax (GST) Exemption 

The generation-skipping tax (GST), also sometimes called the generation-skipping transfer tax, can be incurred when grandparents directly transfer money or property to their grandchildren without first leaving it to their parents.

The GST doesn't just apply to grandchildren. It also addresses gifts or transfers made to other family members and to unrelated individuals who are at least 37 1/2 years younger than the donor. All such beneficiaries are referred to as "skip persons."

Why Skip?
The parent's generation is skipped to avoid an inheritance being subject to estate taxes twice—once when it moves from the grandparents to their children, then from those children to their children. The Internal Revenue Code (IRC) has therefore applied an additional tax to these inheritances since 1976, which was repealed in 1986, and only applies to generation-skipping transfers made on or after that date. Older irrevocable trusts are grandfathered and exempt from the GST to compensate for estate taxes that might otherwise have been avoided.

Trusts Can Be Skip Persons, Too
The GST can be levied on both direct transfers to these beneficiaries and gifts made to them through trusts. Trusts are also considered to be skip persons under some circumstances: All beneficiaries of the trust are skip persons to the donor or no dispositions of income or property are to be made to anyone who is not a skip person.

These individuals must have a "beneficial interest" in the trust. This means they have a present and immediate right to the trust's principal and interest earned.

An Exception for Certain Descendants
IRC Section 2651(e) makes an exception for grandchildren whose parents have predeceased them. In this case, the children effectively move up into their parents' place in-line so the GST no longer applies to them—the gift isn't skipping a generation.

The Generation-Skipping Tax Exemption
An exemption is an amount that can be directly transferred to grandchildren or into a generation-skipping trust for the benefit of grandchildren without incurring a federal GST. The GST shares the same lifetime exemption as the federal estate and gift taxes, and that exemption is pretty significant as of 2020.

Under the provisions of the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act of 2010, the federal GST was repealed for most of that year. It was reinstated on Dec. 17, 2010, however.5 The exemption was $5 million at that time. Any gifts made over this amount were subject to a 35% tax rate.

The federal GST exemption increased to $5.12 million in 2012, and the tax rate remained steady. Then came the American Taxpayer Relief Act (ATRA).

Under the terms of ATRA, the GST tax exemption increased to $5.25 million but the GST tax rate jumped to 40%. ATRA also indexed the exemption for inflation, so it has subsequently increased from year to year. The 2014 generation-skipping transfer tax exemption went up to $5.34 million, and as of 2016, it was set at $5.45 million. Then in 2017, it increased to $5.49 million.7

When the Tax Cuts and Jobs Act (TCJA) went into effect in 2018, this legislation more or less doubled the exemption to $11.18 million. This allows grandparents to give away a lot of money and property, but it might not be permanent. The TCJA and most of its terms are set to expire at the end of 2025 unless Congress takes steps to renew it. The GST tax rate remains at 40%.

Married couples can double these exemption amounts, resulting in a significant cash and property that can be transferred without taxation. The average taxpayer will most likely never have to worry about these rules. Those for whom they're a concern should speak to an estate planning attorney for guidance as to how to set up their estates for maximum protection.

The Annual GST Exclusion
The IRC also provides for an annual exclusion, just as it does for gift taxes. You can give away up to $15,000 per person per year as of 2020 without incurring the GST. Married couples can double this amount because they're each entitled to give $15,000.

"Indirect" Skips
Gifts made to skip persons either outright or through a trust are referred to as "direct" skips. Paying any GST that comes due at the time rather than applying any part of the lifetime exemption turns the direct skip into an "indirect" skip. The tax must typically be paid in the year the gift is made.

How to Report GST Gifts
All direct skips in excess of the $15,000 annual exclusion are to be reported on IRS Form 709, the U.S. Gift (and Generation-Skipping Transfer) Tax Return. They're entered in Part II of Schedule A. If you enter them on Schedule C of Form 709 as well, they're direct skips and they're tallied up over the years to be applied against the $11.18 million lifetime exemption. Part III of Schedule A records indirect skips.

Your direct skips are subtracted from the lifetime exemption each year you do this, ultimately leaving less of the exemption to protect your estate from estate taxes at the time of your death.

State-Level GST Taxes
Many states that collect state estate taxes also collect state generation-skipping transfer taxes. Check with your state taxing authority, your accountant, or your estate planning attorney to learn the rules in your location.


A Qualified Disclaimer

Disclaiming an interest in property has always been a way to add flexibility to an estate plan. By exercising of a timely qualified disclaimer, the disclaimant effectively moves assets to another individual, or to a trust, without incurring any gift tax. Consequently, disclaimer planning takes center-stage in many estate plans these days by spouses to shift the testamentary transfer of an interest from the unlimited marital deduction to a trust for the survivor’s lifetime benefit, e.g. the shift of assets from an outright gift to the surviving spouse, to a credit shelter trust that is established for the spouse’s lifetime benefit sheltered by the deceased spouse’s applicable exemption amount.

Why disclaim?
The five reasons one would choose to disclaim are to save taxes, protect assets, avoid additional costs, provide gifts, correct unintended consequences, or some variation/mixture of the five.

Reduce the size of your estate
The federal estate tax exclusion is $11.58 million per individual or $23.16 million per couple (2020). At one time this was the main reason to file a disclaimer, but not so much anymore. Not many individuals or couples have estates valued that high.

However, if you live in a state that has an estate or inheritance tax, yes, they are different, disclaiming may be a good strategy — an estate tax taxes the decedent’s estate, an inheritance tax taxes the recipient. Only one state, Maryland, has both! Check the Tax Foundation to find out what your state has.

If you’re subject to either the federal estate tax or state inheritance or estate taxes, then yes, it may make sense to disclaim an inheritance and let it pass to the next beneficiary in line if they’re taxed at lower rates.

Prevent higher current taxation
If you’ve been left an IRA or other income-producing asset and accepting it will bump you into a higher tax bracket, and you’re in a position not to need it, then filing a disclaimer could benefit you and the next heir in line. This is especially true if that person is in a lower tax bracket, or in the case of an inherited IRA or annuity, younger AND in a lower tax bracket. They can stretch out distributions over a more extended period. Read my blog posts about Inherited IRA and Inherited Annuity options to learn more.

Maybe you feel generous and want to make a gift. Disclaiming is an efficient way to do that.

Everyone has an annual gift exclusion of $15,000, or $30,000 if married and decide to team up on the gift (2020). If you give gifts more than the annual exclusion amount, you have to file a gift tax return. That doesn’t mean you’ll owe tax, because everyone has a lifetime exclusion amount of $11.58 million (2019), which equals the estate tax exemption.

The point here is you can use disclaiming to give a gift, but not have it count as a gift, and not have to file a gift tax return. Does that make sense? If you want to learn more, read my post Understanding the Gift Tax.

Correcting gifts
Sometimes the best intentions go awry. A disclaimer can help realize the original intent by making it more equal for all beneficiaries.

For example, in her will, Mary stipulated that stocks A-M were left to her son, and stocks N-Z went to her daughter. Between the time the will was written and Mary’s passing there were so many mergers and spin-offs causing the various companies to change names that her son, who inherited stocks A-M, was left with a much lower inheritance compared to her daughter, who inherited stocks N-Z.

That was not the original intent. If the daughter felt bad for her brother, and if he was the next beneficiary in line (critical point), she could choose to disclaim some of the stocks to try to equal out their inheritance. If she doesn’t like her brother, then it’s too bad for him, it’s her prerogative to disclaim. Estate issues like this also speak to the larger point of proper estate planning, so something like this doesn’t happen.

Asset protection
Disclaiming gets tricky when it comes to asset protection, not that it’s a piece of cake in the previous reasons mentioned above, but when you’re planning your estate, a disclaimer can be incorporated to protect assets.

Wills can be designed to allow the surviving spouse to disclaim the assets. The assets then move into a protected trust for the surviving spouse, allowing the survivor (and heirs) to benefit from the assets, but have them sheltered from future creditors and any potential future remarriages.

Disclaiming is a permanent decision. There are no do-overs. It’s critical to consider disclaiming carefully. Can you afford to pass up the inheritance and are you 100%, without a doubt, confident it is the best financial move. Once you disclaim, you have no recourse to change your mind.

Additionally, the beneficiary can disclaim only a portion of an inherited IRA or asset, allowing some to flow to the contingent beneficiary(s). Partial disclaiming is either a specific dollar or percentage amount as of the date of death.

However, when done in this manner, all income attributable to the disclaimed portion must be disclaimed as well. If the value of the asset was $250,000 on the date of death, and the primary beneficiary disclaimed 50%, then the primary beneficiary would receive $125,000 plus the gains or minus the losses based on that amount. The balance will go to the next beneficiary(s).

You need to seek the advice of an estate planning attorney who specializes in this strategy.
Disclaimer of Property Interest: A disclaimer is governed by the property laws of each state.

IMPORTANT NOTE: Although many people discuss using disclaimers in their estate planning, often they are established too late to be effective.



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