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Estate and Gift Taxes Have Been Clarified Thanks to the Fiscal Cliff Legislation

A single, unified exemption is available to taxpayers for the estate and gift taxes. A taxpayer can use the exemption to offset otherwise taxable lifetime gifts, and the taxpayer’s estate can use the amount remaining at his or her death to offset otherwise taxable bequests. The amount of the exemption was a major issue throughout 2012. That exemption was set at $5 million, adjusted for inflation. The inflation adjusted amount for 2012 was $5.12 million. At that level, relatively few estates owed federal estate tax.

However, the law in effect during 2012 called for the exemption to return to its 2003 level of $1 million in 2013. That would have exposed many estates to federal estate tax, with rates as high as 55%. Instead, Congress largely left the 2012 estate and gift tax rules in place. The unified federal estate and gift tax exemption for 2013 and future years has been permanently set at $5 million adjusted for inflation, with the inflation-adjusted amount for 2013 being $5.25 million. Therefore, estates of people who die with a net worth under $5.25 million and did not make significant gifts during their lifetime generally will not have to pay estate tax. The only major estate tax change in the new law regards the maximum federal estate tax rate, which has been increased from 35% in 2012 to 40% in 2013 and subsequent years. Example 1: Anna Carter dies in 2013, when the exemption is $5.25 million. Anna did not use any of her exemption amount on gifts during her lifetime and leaves an estate valued at $6 million. The $750,000 over the exemption amount will be taxed at the maximum rate of 40%, so Anna’s estate will owe $300,000 (40% of $750,000) in federal estate tax.

Preserving portability

With a $5.25 million federal estate and gift tax exemption amount, a married couple that does not use the exemption to offset any lifetime gifts can potentially leave up to $10.5 million in assets free of estate tax.

In fact, the new tax law makes that simpler to do than has been the case in the past because Congress made permanent what had been a temporary “portability” provision. In prior years, lack of portability created problems for many married couples. Example 2: Barry and Carla Duncan, a married couple, had total assets of $8 million. Barry died in 2009 and left all of his assets to Carla. Because one spouse’s bequest to the other spouse typically avoids estate tax, regardless of the amount, no estate tax was due.

Assume Carla dies in 2013 with an $8 million estate, and she did not use any of her exemption amount on lifetime gifts. She’ll be $2.75 million over the $5.25 million exemption amount, and her estate will owe $1.1 million in federal tax, at a 40% rate. To remedy such outcomes, Congress created a temporary portability provision for 2011, a provision that’s now a permanent part of the tax code.

With portability, any unused portion of a deceased spouse’s exemption amount can be used by the surviving spouse’s estate. Originally, Congress created this portability opportunity only for deaths in 2011 and 2012. The new law makes portability permanent. Example 3: If Barry Duncan had died in January 2013, leaving all of his assets to Carla, he would have left $5.25 million of his exemption unused. That amount can be transferred to Carla, if Barry’s executor makes a timely election to do so on a properly filed estate tax return, IRS Form 706. If Carla then dies in December 2013 without using any of her exemption for gifts, her estate would have a total exemption of $10.5 million (her own $5.25 million exemption and a similar one from Barry). Carla’s $8 million estate wouldn’t be taxed by the federal government, for a $1.1 million tax saving. The new tax law also preserves the federal tax deduction for state estate taxes. This provision should remind you that estates may owe state estate tax even if they are exempt from federal estate tax. Example 4: Edward Franklin dies in 2013 with a $3 million estate, so he owes no federal estate tax. However, Edward’s home state exempts only $1 million of assets from state estate tax. His estate is $2 million over the threshold; depending on the state’s tax rates, Edward’s estate may owe many thousands of dollars in state estate tax. The bottom line is that you should not ignore estate tax planning, even if you have little concern about federal estate tax. Our office can work with you on strategies to reduce exposure to estate tax, state or federal.

Generous gifts

As noted above, you can use your unified federal estate and gift tax exemption amount to offset otherwise taxable lifetime gifts, thus reducing the amount of gift tax you have to pay. However, using the exemption for lifetime gifts reduces the amount of the exemption available to your estate to offset otherwise taxable bequests and reduce the amount of the estate tax. Example 5: Nancy Harris has never made any taxable gifts. In 2013, she gives $1 million to her daughter Lisa. The first $14,000 of that gift is tax free, covered by the annual gift tax exclusion for 2013. The other $986,000 is considered a taxable gift but Nancy owes no gift tax because of the lifetime gift tax exemption. After making the gift, Nancy’s lifetime gift-tax exemption is $4,264,000: her original $5,250,000 exemption minus the taxable gift of $986,000. That $4,264,000 exemption, indexed for future inflation, can shelter future gifts or bequests from tax. What’s more, the concept of portability, explained earlier in this article, also applies to gift tax, so once a surviving spouse has increased his or her exemption by the deceased spouse’s unused exemption amount, that increased amount can be used to offset either gift or estate tax. Example 6: Assume that the transfer tax exemption, which is $5.25 million in 2013, rises to $6 million in a future year, and the annual gift tax exclusion remains $14,000. Nancy Harris dies that same year, having made no additional taxable gifts. Nancy leaves all of her assets to her husband, Pete, thus incurring no estate tax. In this scenario, Nancy’s unused exemption is $5,014,000: her $6 million exemption minus $986,000 in taxable gifts. Assume that Pete has not made any taxable gifts. Pete could have a total exemption of $11,014,000 in this example, including Nancy’s unused amount. Pete could make up to $11,014,000 in tax-free gifts, and when he died, any unused gift tax exemption would be available to provide estate tax shelter. In addition, the generation skipping transfer (GST) tax exemption also is $5.25 million in 2013, indexed to inflation. However, portability does not apply to the GST tax.

Copyright AICPA

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