by Bob Rywick
In doing estate planning for a married client, you should generally plan for the client’s spouse at the same time. Planning should involve determining whether lifetime gifts should be made from one spouse (usually the wealthier spouse) to the other.
Such lifetime gifts should be viewed for their effect on the estates of both the donor-spouse and the donee-spouse, and should be made in order to minimize estate taxes on testamentary transfers to be made by the spouses.
Observation: While estate tax is scheduled to be repealed for individuals dying in 2010, it is scheduled to go back into effect for individuals dying after 2010 with a higher maximum tax rate and a lower unified credit exclusion amount than is currently in effect for decedents dying in 2004 and 2005.
My best guess is that the complete repeal of the estate tax will not take effect in 2010 as now scheduled, and neither will it be allowed to come back into effect in 2011 with higher maximum tax rates and a lower exclusion amount than are now in effect.
It is more likely that a compromise will be reached that will result in a lower maximum estate tax rate (perhaps 40 percent instead of the 48 percent in effect in 2004) and a higher exclusion amount (probably between $3 million and $5 million).
When lifetime gifts are most advantageous
Mainly for tax reasons, lifetime gifts to a spouse will be most advantageous in the following circumstances:
- The wealthier spouse’s estate is more than the unified credit exclusion amount available for estate tax purposes ($1.5 million in 2004 and 2005, less any part of the exclusion amount that was previously used on gift tax returns) and the donee-spouse’s estate before taking any gift into account is less than the available unified credit exclusion amount.
Example 1: Your client owns property in her own name of about $2.5 million dollars and her husband owns property in his name of about $500,000. They do not have any jointly owned property. If your client gives property worth $1 million to her husband, each will be able to use the maximum available unified credit exclusion amount to effectively reduce each taxable estate to zero.
- The age and health of the wealthier spouse indicate that he or she is likely to be the surviving spouse.
Observation: If the wealthier spouse were certain to die first, there usually would be no advantage in making lifetime gifts just to save estate taxes provided that the wealthier spouse’s entire estate didn’t end up being taxed in the survivor’s estate.In other words, the wealthier spouse’s entire estate should not be given to the surviving spouse in such a way as to cause the wealthier spouse’s entire estate to qualify for the marital deduction and, thus, be taxed in the survivor’s estate.
Proper use of credit shelter trusts, or making some gifts to beneficiaries other than the other spouse, will result in the full unified credit exclusion amount being used in the wealthier spouse’s estate while minimizing the amount that will be taxed in the surviving spouse’s estate.
Example 2: The same facts apply as in Example 1, and your client makes no lifetime gifts to her husband. If she dies in 2004 or 2005 leaving all her property outright to her husband, the entire $2.5 million would be taxable in his estate. Including his own property, worth about $500,000, his taxable estate will be about $3 million.
If she leaves $1.5 million to him in a credit shelter trust, only $1 million will be taxable in his estate since only that amount will qualify for the marital deduction in her estate, and his total taxable estate will be only $1.5 million. No estate tax will be due from her estate since the unified credit exclusion amount of $1.5 million will shelter the $1.5 million part of her estate that does not qualify for the marital deduction from any estate tax. For the same reason, no estate tax will be due from his estate.
Observation: The unified credit exclusion amount is scheduled to increase to $2 million in 2006, 2007 and 2008, and to $3.5 million in 2009, the year before the estate tax is repealed. Under current law, the estate tax is scheduled to go back into effect in 2011 with the exclusion amount reduced to $1 million.
Recommendation: If the entire property of the first spouse to die is to be used for the benefit of the surviving spouse, consider putting a substantial part of that property in a Qualified Terminal Interest Property Trust, which will pay the income of the trust to the surviving spouse for life. This allows the executor to determine what part of the trust needs to qualify for the marital deduction in order to reduce the estate tax on the estate of the first spouse to die to zero.
Example 3: The same facts apply as in Example 2, except that your client’s husband dies before any lifetime gifts are made to him, and he leaves his entire $500,000 estate to her in a QTIP trust. Your client is his executrix, and does not elect to have any part of the trust qualify for the marital deduction. Accordingly, no part of his estate will be taxable in her estate, and no estate tax will be paid on his estate since the entire estate is less than the available unified credit exclusion amount of $1.5 million.
However, when your client dies, the excess of the amount of her estate over the unified credit exclusion amount will be subject to tax in her estate. If she had made a $1 million gift to her husband before he died, he could have given that back to her in a QTIP trust, and as long as she didn’t elect to have any part of the QTIP trust qualify for the marital deduction, no part of that $1 million would be taxed in her estate.
There would be no estate tax on his estate either, since the total amount of his estate would not be more than the unified credit exclusion amount.
- The spouses’ marriage is secure and likely to endure. If this is not so, the wealthier spouse may be giving away property that will not go to her ultimate beneficiaries after the other spouse dies.
- The ultimate beneficiaries of the estates of both spouses will be the same.
Observation: This is less important if the gift to the donee-spouse is made in the form of a QTIP trust that qualifies for the gift tax marital deduction, and provides who the ultimate beneficiaries of the trust will be.Generation-skipping transfer taxes
Each spouse is entitled to a generation-skipping transfer exemption that is equal to the unified credit exclusion amount in tax years after 2003 and before 2010. Thus, for 2004 and 2005, the GST exemption amount is $1.5 million for each spouse. This amount can be allocated by the individual (or his executor) to any property with respect to which that individual is the transferor.
To avoid waste of the GST exemption of the first spouse to die, that spouse must own property equal in amount to his remaining GST exemption. Also, his will (or other dispositive document) must pass the property in such a way that he remains the transferor of the property for GST tax purposes, since the GST exemption can be effectively allocated only to such property.
Suppose that the wealthier spouse owns property equal to, or greater in amount than, the couple’s combined GST exemptions. In such a case, consider transferring property from the wealthier spouse to the other spouse so that the other spouse’s estate equals his remaining GST exemption. This ensures that both spouses’ GST exemptions will be used in full, regardless of the order of their deaths.
Basis as a factor
If one spouse owns assets with a basis that is substantially lower than their fair market value (appreciated assets) that she does not plan to sell any time soon, and the other spouse is more likely to die first, consider transferring some of these assets to the other spouse to get a stepped-up basis on that spouse’s death.
Note, however, that if the assets are reacquired by the donor-spouse on the death of the donee-spouse, the basis of the assets is stepped up in the hands of the donor-spouse only if the donee-spouse lived for at least a year after the date of the gift.
On the other hand, if the owner of the appreciated assets is likely to die first, then you should avoid making lifetime gifts so that the other spouse (or other beneficiary) will get a stepped-up basis in those assets on the death of the owner.
If one of the spouses owns assets with a basis that is higher than their current fair market value (depreciated assets), and that spouse is likely to die first, consider transferring those assets to the other spouse so that the surviving spouse won’t get a stepped-down basis in the assets when the owner-spouse dies. Such a transfer could be made any time before the death of the owner, since there is no requirement that the donee-spouse hold the assets for any particular period to avoid getting a stepped-down basis on the donor-spouse’s death.
Income taxes as a factor
Gifts to a spouse will generally provide no significant federal income tax advantages since the income of both spouses will be taxed on a joint return in roughly the same way that it would be taxed if it were solely the income of one spouse.
State and local income tax advantages may, however, be significant in those states that allow separate income tax computations on each spouse’s income and that do not permit income-splitting on a joint return. Gifts from one spouse to the other of income-producing property will split the income for state and local income tax purposes between the spouses, thereby lowering the income tax bracket rates at which the income is taxed.
Observation: To be able to file separate state and local income tax returns, some states require the spouses to file separate federal income tax returns. If the spouses have roughly equal taxable incomes, this should not be a problem, since the total federal income taxes should be about the same regardless of whether separate or joint returns are filed.
Bob Rywick is an executive editor at RIA, in New York, and an estate planning attorney.
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