There are numerous different legal devices used in the field of estate planning, and the right choices will depend upon the unique nature of each respective situation. We are going to address advanced estate planning tools in some upcoming blog posts, and we will start right here with two trusts that can be quite useful for high net worth individuals.

Federal Estate Tax

Both of the trusts that we are going to look at here are used to obtain estate tax efficiency. Because of this, we should explain some facts about the estate tax before we proceed.

Most people do not have to worry about the federal death tax, because there is an exclusion or credit that is relatively high. This is the amount that you can transfer before the tax would kick in.

At the time of this writing in 2019, the exact amount of the estate tax exclusion is $11.4 million. Last year, it was $11.18 million. There are annual adjustments to account for inflation, so in 2020 the estate tax exclusion will be $5.18 million. The top rate of the tax is 40%, so this is a very significant level of taxation.

We should be clear about the way that the estate tax is applied. The exclusion amount can be transferred free of taxation, and only the remainder would be subject to the estate tax.

New York also has an estate tax. In 2019, the New York estate tax exclusion amount is $5.74 Million; as of the date of this writing, New York has not yet released the exclusion amount for 2020. While the New York estate tax rate is lower than the federal rate, it may apply against more of the estate. In fact, if the estate value is just $287,000 above the exclusion amount, the entire estate is subject to the tax. This result often is referred to as the New York estate tax “cliff.”

To explain through an extremely simplistic example, if an estate that was valued at $12.4 million was distributed to the heirs this year, there would be an $11.4 million exemption. As a result, only $1 million of the estate would be taxable.

The estate tax exclusion is allotted to each individual taxpayer, so a married couple would have two separate exemptions to use. Since the estate tax exclusion is portable, a surviving spouse would e able to use the exclusion that was earmarked for his or her deceased spouse. The survivor would have two exclusions to utilize under currently existing laws, and this was not always the case. However, this result is not automatic, and without proper planning the surviving spouse will lose one of the exclusion amounts. Also, portability only applies to the federal estate tax exclusion; New York does not have portability.

Another thing to understand about the estate tax and spouses is that there is an unlimited marital deduction. If you are legally married in the eyes of the law, you can transfer any amount of property to your spouse in a tax-free manner, as long as your spouse is an American citizen.

There is a gift tax that is unified with the estate tax, so the exclusion is a unified gift/estate tax exclusion. If you were to give away an amount that is equal to the exclusion while you are living, all of your estate would be subject to the death tax.

Qualified Domestic Trusts

We closed the previous section with some words about the marital deduction for a reason. If you are married to someone from another country, you cannot use the unlimited marital deduction to transfer assets to your spouse tax-free. However, you could gain tax efficiency through the utilization of a qualified domestic trust.

To implement this strategy, you fund the trust, and your spouse would be the first beneficiary. Your children or anyone else that you want to name would be the successor beneficiaries.

If you predecease your spouse, the trustee would be able to distribute the earnings from the trust to the surviving spouse. The estate tax would not be a factor, but the distributions would be subject to regular income taxes.

After the death of your surviving spouse, the successor beneficiaries would assume ownership of the remainder in the trust. The estate tax would be applicable, but there would be just one round of taxation.

Qualified Personal Residence Trusts

With a qualified personal residence trust, you convey your home into the trust. When you do this, you are removing the home from your estate for tax purposes. You record a prescribed term during which you will continue to live in the home rent-free. This is called the retained income period.

In the trust declaration, you name a beneficiary that will assume ownership of the home after the expiration of the term. This transfer would constitute a taxable gift under the gift tax laws, but the ultimate transfer would take place at a tax discount.

To explain by way of example, let’s say that you set a 10 year retained income period. The value of the home for tax purposes would be determined by the IRS based on the fact that the beneficiary could not assume ownership for a decade. No one would pay full fair market value for a piece of property under these terms, and this is taken into account.

The taxable value would be less than the actual value, so the beneficiary would pay the tax on a fraction of the market value of the home.

Schedule a Consultation!

Here in New York we have a state-level estate tax to contend with along with the federal tax, and it has a lower exclusion. You should definitely schedule a consultation so you can discuss your situation with us if you have concerns.

We can be reached by phone at 585-374-5210, and there is a contact form on this website that you can use to send us a message.