Death Taxes
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At the time of your death, the assets which you have accumulated during a lifetime of hard work are subject to tax by both the federal government, and the state government where you are domiciled. Any real estate will be subject to tax at its location.
I. Federal Estate Tax
A. In General:
The Federal Estate Tax (FET) applies to estates of $650,000.00 or more in 1999.(1) The marginal rate of tax is 37% on amounts over $650,000.00, rising to 55% on amounts over $3,000,000.00. There is an additional 5% tax on certain amounts over $10,000,000.00.
The FET and the Federal Gift Tax (FGT) are "unified". That is, taxable lifetime gifts (gifts which exceed $10,000.00 per donee per year*) are aggregated with the taxable estate in order to calculate the tax.
There is a "unified credit" of $211,300* which offsets the FET-FGT on the first $650,000.00* of taxable assets. This is why the tax is applicable only to estates which exceed $650,000.00.*
There is also a "credit for state death taxes", which ranges from 0.8% to 16%. This is really a revenue-sharing device whereby the federal government allows the state government to claim a portion of the taxes. This credit is allowed only if the state in fact collects the amount. A state is also free to impose death taxes which exceed this credit.
A "credit for prior transfers" may apply when a decedent has received a taxable inheritance within the 10 years prior to his or her own death.
Deductions are allowed for debts of the decedent, funeral and administration expenses, charitable bequests, and bequests to the decedent's spouse.
B. Marital Deduction:
The most important deduction from the FET-FGT is the marital deduction. All amounts given to your spouse, either during lifetime or at death, are eligible for a 100% marital deduction. Thus, if you leave everything to your spouse, there will be no FET.
The marital deduction provides a strong incentive to give property to your spouse. However, there are situations, such as second marriages, where a decedent may want to provide for children as well as for spouse. Since 1982, it has been possible to obtain the marital deduction while preserving principal for children, through a "qualified terminable interest property" (Q-TIP) trust. Such a trust provides income to spouse for life. During spouse's life, principal may or may not be made available to spouse, but only after spouse has died may the principal be used by anyone else.
One consequence of the Q-TIP election is that the trust principal will be included in spouse's later estate for FET purposes. Provision should be made to pay the resulting death taxes from the trust, rather than from spouse's own assets.
There are many other forms of trust which will qualify for the marital deduction. A trust which ends upon the remarriage of the spouse will not qualify.
To summarize, the marital deduction can be obtained, at a minimum, by giving spouse income for life. At the maximum, property would be given to spouse outright, without restriction.
If your spouse is not a United States citizen, no marital deduction will be allowed, except for property placed in a "qualified domestic trust". The FET will be imposed when principal is distributed from this trust. The surviving spouse may create such a trust if the decedent failed to do so. Apparently Congress feared that non-citizen spouses would take property out of reach of the IRS.
C. Credit Trust (or By-Pass Trust):
Please note that you and your spouse could each leave $650,000.00 (1999 figure) to your children free of tax (because of your unified credits). That is $1,300,000.00 in total from the two estates. But if you leave everything to your spouse, then at the time of your spouse's death, your spouse can only leave $650,000.00 in total to your children free of tax. The additional tax to your children (on the $650,000.00 you didn't leave to your children) is between $258,500.00 and $357,500.00, depending on your spouse's tax bracket.
How can you provide for your spouse and also save the taxes on the second $650,000.00? One common solution to this problem is a trust (called variously a "credit", "by-pass", "non-marital", "residuary" and "B" trust) which pays income to spouse, and at spouse's death, principal to children. (A bank account or a share of stock is principal; the interest or divided is income.) The first decedent creates this trust, funding it with up to $650,000.00 (the maximum amount shielded from tax in the first estate--1999 figure). This trust will not be included in the spouse's later estate. Thus the $650,000.00 in the credit trust of the first decedent, plus $650,000.00 in the spouse's later estate, passes free of tax to the children.
The credit trust is a useful compromise between providing for spouse and minimizing taxes for children. The maximum benefit which may be given to spouse, without causing the trust to be included in spouse's later estate, is:
1. all of the income
2. principal, if needed for support
3. the greater of $5,000.00 or 5% of the principal, each year, on demand
4. power to direct by will who will receive the principal, so long as it is not paid to spouse's estate, the spouse's creditors, or the creditors of spouse's estate.
If item 3 is selected, the amount of $5,000.00 or 5% of the trust principal will be included in the spouse's later estate. (An independent trustee may be given discretion to be even more generous to spouse, but spouse cannot have the right to principal except for "health, maintenance, support and education.")
Please note that the credit trust provides no tax benefit for decedent or for the surviving spouse. The tax savings occurs at the death of the surviving spouse, for the benefit of children. Meanwhile, the surviving spouse must tolerate the inconvenience of having limited rights to principal. This means, for instance, that the trustee may invest not to maximize income (which spouse may desire) nor to maximize growth (which children may desire), but to provide a "reasonable" income and a reasonable prospect for growth of principal. Whether this inconvenience is viewed as large or small will depend on the spouse's other assets, and the relationship between spouse and children.
The secret of the credit trust is that, for federal estate tax purposes, it is treated as passing directly from the first decedent to the children, whereas in fact the trust does not pass to the children until spouse dies, which may be many years later. During those years the principal of the trust may have grown much larger than $650,000, and spouse will have benefitted from the income, and perhaps from principal as well.
Please note that the credit trust cannot be fully funded unless the decedent had at least $650,000.00 in separate name. Joint property will not fund this trust. Life insurance and pension will not fund this trust unless payable to the trust or to the estate. Failure to properly title assets can upset the estate plan.
II. Generation Skipping Tax (GST)
A typical generation skipping trust is one in which generation 1 establishes a trust to pay income to generation 2 and generation 3, with principal remainder to generation 4. The FET would apply only at the deaths of generation 1 and 4. The GST is designed to apply to generations 2 and 3.
The GST is a tax which should be avoided, if possible. Its rate is 55%, and there is no marital deduction. There is a $1,000,000.00 exemption, applicable at the generation 1 level, which may be continued by trust as long as a trust can last (until recently, the life of a person now living plus 21 years; but New Jersey and some other states have recently lifted this limit).
In planning, we try to avoid the GST by using the exemption, or by subjecting property to the FET, which may be lower. If a trust may become subject to the GST, we try to divide it into two trusts, one of which is GST exempt and one of which is not. It is often difficult to predict whether a trust will become subject to the GST, or to know how and where to allocate the GST exemption.
The GST applies to gifts to grandchildren. If the gift exceeds $10,000.00 in one year, you must use up part of your $1,000,000.00 exemption.
III. Federal Excise Tax on Excess Pension
This 15% tax on "excess" (large) pensions has been repealed by the 1997 act. Nevertheless, the combined impact of the federal income tax and the federal estate tax can reach 73% - even after the "relief" of this repealer.
IV. New Jersey Death Taxes
A. Transfer Inheritance Tax:
In contrast to the FET, which is based upon the decedent's total assets, the New Jersey Transfer Inheritance Tax is based upon the inheritance of each beneficiary, and the "class" of the beneficiary.
In the late 1980's New Jersey enacted a full marital deduction, and it has reduced taxes upon lineal decedents and lineal ancestors (class A beneficiaries) to zero. Thus for many persons this tax is no longer applicable.
Class C beneficiaries (brothers, sisters, sons-in-law, daughters-in-law) are subject to tax of 11% to 16% on amounts over $25,000.00.
Class D beneficiaries (everyone else) are subject to tax of 15% to 16% on amounts over $499.00.
Most charities (Class E beneficiaries) are exempt.
Life insurance policies paid directly to any person are exempt. If paid to your estate, the policy may be taxed, according to the identity of the ultimate beneficiary.
B. New Jersey Estate Tax:
New Jersey also has an estate tax, which is designed to pick up the amount by which the federal credit for state death taxes exceeds the Inheritance Tax. If it were not paid to New Jersey, it would have to be paid to IRS.
Until recently, the Inheritance Tax was rarely less than the federal credit. With the revisions to the Inheritance Tax, the Estate Tax becomes much more important. It will apply only in cases where there is a federal estate tax - that is, taxable estate of more than $650,000.00.
1. The 1997 tax act raised these figures. The $650,000 figure rises to to $1,000,000 by year 2006. The $10,000 figure will be indexed to inflation. The $650,000 may be increased to as much as $1,300,000 in estates where a family business is 50% or more of the value of the estate, subject to detailed qualification and recapture rules.
© 1999 Capehart & Scatchard, P.A.