Equalizing Taxable Estates: Minimizing Estate Tax Liability - Spouses

What Does Equalizing Taxable Estates Entail?

Equalizing the taxable estates refers to arranging the estates of spouses to minimize the total estate tax liability. Progressive federal estate tax rates are the underlying premise (i.e., the tax rate increases with the size of the estate). Thus, two estates of equal value pay less estate tax than one estate valued at zero dollars and the other estate valued at all assets. The spouses' objective is to minimize or eliminate potential estate taxes.

In 2013 and subsequent years, estates that exceed the applicable exclusion amount will be taxed at a rate of 40 percent. To ensure lower marginal tax rates, equalizing the taxable estates may not result in tax savings. However, additional reasons for equalizing the taxable estates may exist, such as reducing estate taxes.

Equalizing taxable estates is based on the following fundamental rules and concepts:

The Unlimited Marriage Credit

The IRS treats spouses differently. As long as your surviving spouse is a U.S. citizen, you can transfer any property to him or her without incurring federal gift tax or federal estate tax, provided the transfer is qualified. This is known as the unlimited spouse deduction. The unlimited marital deduction permits a surviving spouse to defer the payment of federal estate tax due upon the death of the first spouse until the death of the second spouse.

Estate tax deferral may be desirable for a variety of reasons, including:

• The value of money over time

• Deferred tax dollars could grow while in the estate of the surviving spouse.

• It is possible to avoid the need for liquid assets in the first spouse's estate to die.

• Avoiding an estate tax audit of the first spouse's estate to die is possible.

• The surviving spouse is taken care of

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 are examples of estate plans that maximize the unlimited marital deduction.

These plans may be desirable for some couples, but leaving all of your assets to your surviving spouse only delays potential estate taxes; they do not eliminate them. If the assets in the surviving spouse's estate are not spent during the surviving spouse's lifetime or grow substantially while in the surviving spouse's possession, the second estate may be subject to a substantial estate tax burden.

Dave and Ann are married, and Dave's estate is worth $20 million. Assume an applicable exclusion amount of $11,580,000 (which will be indexed for inflation after the first spouse dies), a top tax rate of 40 percent, portability, and that values (excluding any unused exclusion) double over time after the first spouse dies. Dave passes away first and leaves Ann $20 million. The transfer to Ann qualifies for the marital deduction, and Dave's estate is not subject to estate tax. Ann is designated as the recipient of Dave's unused exclusion. Ann's $40 million estate exceeds her applicable exclusion amount of $34,740,000 (Ann's $23,160,000 exclusion amount and Dave's $11,580,000 unused exclusion), so a federal estate tax of $2,104,000 is due. After paying federal estate tax, the children only receive $37,896,000. Dave's $10 million estate would have been fully sheltered by his $11,580,000 applicable exclusion amount (assuming Dave transfers the $10 million to a credit shelter trust or beneficiaries other than Ann). Her $23,160,000 applicable exclusion amount would have fully sheltered Ann's $20 million estate, and no estate tax would have been imposed.

Suppose both spouses die in 2011 or later years. In that case, the unused applicable exclusion of the first spouse to die is generally transferable to the second spouse, even if the first spouse took advantage of the unlimited marital deduction to the fullest extent. Nonetheless, the unused applicable exclusion of the first spouse to die is not adjusted for inflation after the first spouse's death.

The Applicable Exclusion Amount

Each person has an exemption that allows them to leave a certain amount of property to anyone free of the federal estate tax. This amount, $11,580,000 in 2020, is the applicable exclusion amount (which can be shielded from federal gift and estate tax by the unified credit). Credit shelter planning entails dividing a married couple's assets so that each spouse fully utilizes his or her applicable exclusion amount.

This assumes that the combined estates of the married couple exceed the applicable exclusion amount for an individual. Each spouse's applicable exclusion amount can be preserved in several ways, including by utilizing a bypass trust, also known as a credit shelter trust, or by 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 own name regardless of who dies first, and (2) if a credit shelter trust is used, drafting the trust so that the surviving spouse is a beneficiary without the trust being includible in the surviving spouse's estate for estate tax purposes.

An attorney with experience in estate planning should draft a credit shelter trust.

Dave and Ann are married, and Dave's estate is worth $20 million. Assume an applicable exclusion amount of $11,580,000 (which will be indexed for inflation after the first spouse dies), a top tax rate of 40 percent, portability, and that values (excluding any unused exclusion) double over time after the first spouse dies. Dave passes away first and leaves Ann $20 million. The transfer to Ann qualifies for the marital deduction, and Dave's estate is not subject to estate tax. Ann is designated as the recipient of Dave's unused exclusion. Ann's $40 million estate exceeds her applicable exclusion amount of $34,740,000 (Ann's $23,160,000 exclusion amount and Dave's $11,580,000 unused exclusion), so a federal estate tax of $2,104,000 is due. After paying federal estate tax, the children only receive $37,896,000.

Example(s): Assume the same facts as in the previous example, except this time, Dave leaves $20 million to Ann and stipulates that anything disclaimed by Ann will be transferred to a disclaimer credit shelter trust. Ann disclaims $10 million. The $10 million transferred to the credit shelter trust is protected by the applicable exclusion amount, the $10 million transferred to Ann is eligible for the marital deduction, and Dave's estate is not subject to estate tax upon his death. At Ann's death, her $23,160,000 applicable exclusion amount fully protects her $20 million estate, and no federal estate tax is due. In addition, the $20 million in the credit shelter trust at the time of Ann's death circumvents Ann's estate, so no estate tax is owed. Because no federal estate tax has been paid, the children receive the entire $40,000,000.

In 2011 and later years, the unused applicable exclusion of a deceased spouse is portable, allowing you and your surviving spouse to fully utilize the applicable exclusion amount without using a credit shelter or bypassing trust. Nonetheless, the unused applicable exclusion of the first spouse to die is not adjusted for inflation after the first spouse's death.

Equalizing Estates and Reducing Overall Taxation

A couple may have any of the following objectives:

• Deferring potential estate taxes until the death of the surviving spouse

• Ensuring that both spouses' estates fully benefit from the applicable exclusion amount

• Equalizing the estate sizes of the spouses to reduce estate taxes

These objectives may not be compatible. For instance, equalizing the estates to reduce total taxes may result in paying some taxes upon the demise of the first spouse. Consequently, your personal circumstances should dictate your strategy (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 method is predicated on the premise that the best results are obtained when both estates are subject to the same marginal tax rate. The unlimited marital deduction facilitates the transfer of property from one spouse to the other to achieve equalization, which can be accomplished through lifetime gifts or bequests at death.

In 2013 and subsequent years, estates that exceed the applicable exclusion amount will be taxed at a rate of 40 percent. To ensure lower marginal tax rates, equalizing the taxable estates may not result in tax savings.

If the wealthier spouse dies first and leaves the surviving spouse an amount equal to one-half of the difference in the value of their estates, the spouses' estates can be equalized. The surviving spouse may also utilize disclaimers for retaining property in the deceased spouse's estate. A qualified terminable interest property (QTIP) trust can also be accomplished equalization.

Dave and Ann are married, and Ann's estate is worth $20 million. Assume an applicable exclusion amount of $11,580,000 (which will be indexed for inflation after the first spouse dies), a top tax rate of 40 percent, portability, and that values (excluding any unused exclusion) double over time after the first spouse dies. Dave dies initially. Ann is designated as the recipient of Dave's unused exclusion. Ann's $40 million estate exceeds her applicable exclusion amount of $34,740,000 (Ann's $23,160,000 exclusion amount and Dave's $11,580,000 unused exclusion), so a federal estate tax of $2,104,000 is due. If Ann had instead transferred $10 million to Dave before his death, Dave's $10 million estate would have been fully sheltered by his $11,580,000 applicable exclusion amount (assuming Dave transfers the $10 million to a credit shelter trust or beneficiaries other than Ann). No estate tax would have been due at either death.

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John M. Lynch, CIMA®, CPWA® Managing Director – LRIG, Financial Advisor – RJFS

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