What is equalizing the taxable estates?
Equalizing the taxable estates refers to methods of arranging the estates of spouses in a way that will result in the least total amount of estate tax liability. Here is the underlying premise: federal estate tax rates are progressive (i.e., the tax rate increases with the size of the estate). Thus, two estates of equal value pay less total estate tax than one estate valued at $0 and the other estate valued at all the assets. The spouses’ goal is to avoid, or even totally eliminate, potential estate taxes.
In 2013 and later years, an estate in excess of the applicable exclusion amount will generally be taxed at a 40% estate tax rate. So there may be no tax savings based on equalizing the taxable estates in order to assure use of lower marginal tax rates. However, there may other reasons for equalizing the taxable estates, including some based on saving estate taxes.
Equalizing the taxable estates is founded upon the following basic rules and principles:
The unlimited marital deduction
The IRS treats spouses in a special way. As long as your surviving spouse is a U.S. citizen, you can transfer any amount of property to him or her without incurring federal gift tax or federal estate tax, as long as the transfer is made in a qualified manner. This is called the unlimited marital deduction. The unlimited marital deduction allows one spouse to defer federal estate tax payable at the death of the first spouse until the death of the second spouse.
Estate tax deferral may be attractive for many reasons, such as:
- The time value of money
- Deferred tax dollars could grow while in the surviving spouse’s estate
- The need for liquidity in the estate of the first spouse to die may be avoided
- An estate tax audit of the estate of the first spouse to die may be avoided
- The surviving spouse is provided for
Estate plans that take full advantage of the unlimited marital deduction include making outright gifts or bequests, titling assets as joint tenancy with rights of survivorship or tenancy by the entirety (or community property in community property states), naming a spouse as the beneficiary of life insurance or retirement plan proceeds, or transferring assets to a trust that qualifies for the unlimited marital deduction.
Though these plans may be desirable to some couples, leaving all your property to your surviving spouse only postpones potential estate taxes; it does not avoid them. In fact, if the assets in the surviving spouse’s estate are not spent during the surviving spouse’s lifetime, or actually grow significantly while in the surviving spouse’s possession, the second estate may be exposed to a considerable estate tax burden.
Dave and Ann are married and Dave has an estate of $23 million. Assume an applicable exclusion amount of $13,610,000 (that will be indexed for inflation after the first spouse dies), a 40% top tax rate, portability, and that values (other than any unused exclusion) double over time after the first spouse dies. Dave dies first and leaves $23 million to Ann. The transfer to Ann qualifies for the marital deduction and no estate tax is due at Dave’s death. Dave’s estate elects to transfer Dave’s unused exclusion to Ann. At Ann’s death, Ann’s $46 million estate is greater than her $40,830,000 applicable exclusion amount (Ann’s $27,220,000 exclusion amount and Dave’s $13,610,000 unused exclusion), and federal estate tax of $2,068,000 is due. The children receive only $43,932,000 after federal estate tax is paid. If Dave instead had transferred $11.5 million to a credit shelter trust and $11.5 million to Ann (qualifying for the marital deduction), Dave’s $11.5 million estate would have been fully sheltered by his $13,610,000 applicable exclusion amount (assuming Dave transfers the $11.5 million to a credit shelter trust or to beneficiaries other than Ann) and Ann’s $23 million estate would have been fully sheltered by her $27,220,000 applicable exclusion amount, and no estate tax would be due at either death.
If both spouses die in 2011 and later years, the unused applicable exclusion of the first spouse to die is portable and can generally be used by the second spouse to die even if the first spouse took full advantage of the unlimited marital deduction. However, the unused applicable exclusion of the first spouse to die is not indexed for inflation after the death of the first spouse.
The applicable exclusion amount
Each individual has an exemption that allows a certain amount of property to be left to anyone free from federal estate tax. This is called the applicable exclusion amount (the amount that can be sheltered from federal gift and estate tax by the unified credit), which is $13,610,000 in 2024.
Credit shelter planning involves the division of assets between the spouses in a marriage so that each person fully utilizes his or her applicable exclusion amount. This assumes that the married couple has combined estates in excess of the applicable exclusion amount for one person. Each spouse’s applicable exclusion amount can be preserved in a variety of ways, such as using a bypass trust, also known as a credit shelter trust, or leaving all property outright to a surviving spouse who then adjusts the amount of the bequests using disclaimers.
There are two essential elements to sheltering the applicable exclusion amount: (1) ensuring that each spouse has at least the applicable exclusion amount in his or her respective name alone regardless of who dies first, and, if used, (2) drawing up a credit shelter trust in such a way as to make the surviving spouse a beneficiary without resulting in the trust being includable in the surviving spouse’s estate for estate tax purposes.
A credit shelter trust should be drafted by an experienced estate planning attorney.
Dave and Ann are married and Dave has an estate of $23 million. Assume an applicable exclusion amount of $13,610,000 (that will be indexed for inflation after the first spouse dies), a 40% top tax rate, portability, and that values (other than any unused exclusion) double over time after the first spouse dies. Dave dies first and leaves $23 million to Ann. The transfer to Ann qualifies for the marital deduction and no estate tax is due at Dave’s death. Dave’s estate elects to transfer Dave’s unused exclusion to Ann. At Ann’s death, Ann’s $46 million estate is greater than her $40,830,000 applicable exclusion amount (Ann’s $27,220,000 exclusion amount and Dave’s $13,610,000 unused exclusion), and federal estate tax of $2,068,000 is due. The children receive only $43,932,000 after federal estate tax is paid.
Assume the same facts as above, except that this time Dave leaves $23 million to Ann and provides that anything disclaimed by Ann passes to a disclaimer credit shelter trust. Ann disclaims $11.5 million. The $11.5 million transferred to the credit shelter trust is protected by the applicable exclusion amount and the $11.5 million transferred to Ann qualifies for the marital deduction, and no estate tax is due at Dave’s death. At Ann’s death, Ann’s $23 million estate is fully protected by her $27,220,000 applicable exclusion amount, and no federal estate tax is due. In addition, the $23 million in the credit shelter trust at Ann’s death bypasses Ann’s estate, so no estate tax is due. The children receive the entire $46,000,000 since no federal estate tax has been paid.
In 2011 and later years, the unused applicable exclusion of a deceased spouse is portable and may allow you and your spouse to take full advantage of the applicable exclusion amount without using a credit shelter or bypass trust. However, the unused applicable exclusion of the first spouse to die is not indexed for inflation after the death of the first spouse.
Equalizing the estates and minimizing overall taxes
A married couple may have any of the following goals:
- Deferring the payment of potential estate taxes until the death of the surviving spouse
- Ensuring that the estates of both spouses take full advantage of the applicable exclusion amount
- Equalizing the sizes of the spouses’ estates to minimize estate taxes
These goals are not necessarily compatible. For example, equalizing the estates to minimize total taxes may result in some taxes being due at the death of the first spouse. Thus, your own personal circumstances should dictate which approach you should take (e.g., you may want to defer taxes if your surviving spouse will need the money for his or her financial well being).
The equalization approach stems from the principal that optimum results are achieved when both estates are subject to the same marginal tax rate. Transferring property from one spouse to the other in order to achieve equalization is facilitated by the unlimited marital deduction, and can be achieved by making lifetime gifts or bequests at death.
In 2013 and later years, an estate in excess of the applicable exclusion amount will generally be taxed at a 40% estate tax rate. So there may be no tax savings based on equalizing the taxable estates in order to assure use of lower marginal tax rates.
The estates of the spouses may be equalized if the wealthier spouse dies first and leaves the surviving spouse an amount equal to one-half difference in the value of their estates. The surviving spouse may also use disclaimers to keep property in the estate of the spouse that dies first. Equalization may also be achieved through the use of a qualified terminable interest property (QTIP) trust.
Dave and Ann are married and Ann has an estate of $23 million. Assume an applicable exclusion amount of $13,610,000 (that will be indexed for inflation after the first spouse dies), a 40% top tax rate, portability, and that values (other than any unused exclusion) double over time after the first spouse dies. Dave dies first. Dave’s estate elects to transfer Dave’s unused exclusion to Ann. At Ann’s death, Ann’s $46 million estate is greater than her $40,830,000 applicable exclusion amount (Ann’s $27,220,000 exclusion amount and Dave’s $13,610,000 unused exclusion), and federal estate tax of $2,068,000 is due. If Ann instead had transferred $11.5 million to Dave prior to his death, Dave’s $11.5 million estate would have been fully sheltered by his $13,610,000 applicable exclusion amount (assuming Dave transfers the $11.5 million to a credit shelter trust or to beneficiaries other than Ann) and Ann’s $23 million estate would have been fully sheltered by her $27,220,000 applicable exclusion amount, and no estate tax would be due at either death.
Prepared by Broadridge Advisor Solutions. © 2024 Broadridge Financial Services, Inc.
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