This article is the sixth in a series of nine articles explaining the Eight Goals of a Good Estate Plan. In this article we will explain estate tax and discuss some tools used to avoid it or minimize it.
What is Estate Tax?
In addition to the taxes that you pay during your lifetime, both the federal and the Illinois state governments require your estate to pay a tax before passing to your heirs. The good news is that both the federal and state estate taxes are subject to exemptions. If the value of your estate is less than the applicable exemption the estate tax in question will not apply. Only amounts over and above the applicable exemption are taxable.
In 2015, the federal estate tax exemption is $5.45 million. This means that if the value of your estate is less than $5.45 million, federal estate tax will not apply to you. If the value of your estate is $6.45 million, only $1 million will be taxable on the federal level (I use the word “only” loosely). The Illinois estate tax exemption for 2015 is $4 million.
How to Avoid Estate Tax
Luckily, we have several relatively inexpensive tools that we can use to legally avoid much or all of the estate tax that would otherwise be imposed on your estate.
AB Trusts
For married clients that are not worried about estate tax avoidance we often suggest one joint revocable living trust as the primary vehicle for their estate. The first line of defense against estate tax is to draft a trust for each client rather than use the joint trust strategy. These trusts are called AB Trusts and their purpose is to allow the unused estate tax exemption of the first spouse to pass away to transfer to the surviving spouse. This essentially doubles the estate tax exemption for a married couple. The federal estate tax exemption is already "portable," meaning that a surviving spouse can take advantage of the unused estate tax exemption of the first spouse to pass without the use of AB Trusts. The Illinois estate tax exemption requires the AB Trust planning technique to become portable.
So how do AB Trusts work? Let’s say that Clark Kent and Lois Lane are married, and Lois, through years of work as an intrepid reporter, has accumulated an estate with a value of $8 million. When Lois passes away, the value of Clark and Louis' assets is $8 million. For the sake of simplicity, we will assume that the assets are all jointly held. All of the assets will pass to Clark free and clear of estate tax due to the Unlimited Marital Deduction, which allows a surviving spouse to inherit an unlimited amount of assets from the other spouse without paying estate tax. Louis' estate tax exemption will not have to be used to transfer the assets from Lois to Clark. If Lois and Clark have an AB Trust in place, Lois' unused Illinois estate tax exemption of $4 million will be transferred to Clark. When Clark passes, his $8 million estate will pass to his children or loved ones free and clear of estate tax, because his AB Trust strategy allows for an $8 million exemption upon Clark's death, rather than the $4 million exemption that would have been available to Clark in the absence of an AB Trust.
Again, while the federal estate tax is automatically portable, the Illinois estate tax is not. With the use of the AB Trust technique, we can achieve a similar effect, essentially raising the Illinois estate tax exemption from $4 million to $8 million for a married couple.
Irrevocable Life Insurance Trusts
Using Irrevocable Life Insurance Trusts, known as ILITs, we have the ability to take the death benefits of your life insurance policies out of your taxable estate. If you have a life insurance policy with a $2 million death benefit, this benefit will use up $2 million of your estate tax exemption in the absence of an ILIT. However, if the insurance policy is owned by an ILIT, the death benefit will not count as part of your estate for estate tax purposes.
You will not be able to change the beneficiaries of any policies that you place in an ILIT, thus the word “irrevocable.” This is usually not a problem for people who want their spouse and/or children to be the beneficiaries of the policies. It is this irrevocable nature of the ILIT that functions to take the insurance policy out of your taxable estate.
GRITs, GRATs, and GRUTs
Grantor Retained Income Trusts (GRITs), Grantor Retained Annuity Trusts (GRATs), and Grantor Retained Unitrusts (GRUTs) are used to allow an asset to appreciate in value while removing such appreciation in value from your taxable estate. These are often used for family businesses or real estate. If you transfer a home worth $100,000.00 to a GRIT, GRAT, or GRUT, and that home appreciates in value to $500,000.00. Then, at the time of your death, only the value of the home at the time that you transferred it into the trust ($100,000.00) will be taxable. The appreciation ($400,000.00) will not be taxable.
The tradeoff is that, by transferring property to a GRIT, GRAT, or GRUT, you are giving up the ability to sell the property in the trust. Instead, for a fixed number of years you will receive annual payments from the trust either of income generated from the principal asset (GRIT), a fixed dollar amount (GRAT), or a percentage calculated annually based on the value of the trust (GRUT).Upon the termination of the term of the trust, the trustee will transfer the assets in the trust to the trust’s beneficiaries.
Gifting Strategies
Another way to reduce your taxable estate is to give it away to your intended beneficiaries during your lifetime. In 2015 you can give $14,000.00 annually to each individual without paying gift tax. An advanced discussion of gifting strategies is outside the scope of this article, and will be addressed in a future article.
Generation Skipping Trusts
Generation Skipping Trusts, known as Dynasty Trusts, are used to pass as much generational wealth as possible to your grandchildren or great-grandchildren. The trusts direct that a certain portion of your assets will not pass to the next generation of your family, but will skip that generation, passing instead directly to that generation’s descendants. This allows those assets to pass to the third generation of the family without being taxed in the estates of the second generation.
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