The objective of this discussion is to review some of the myths and realities of estate planning. A number of articles have been written on the subject but let’s see if we can’t put a different spin on it by keeping it simple. By dispelling some of the common misconceptions, we will have a better understanding of how important it is to take positive action to keep our estate plans in order.
The Economic Growth and Tax Reconciliation Relief Act of 2001 (EGTRRA) threw many individuals for a loop when it came to estate planning. Tax laws are never simple but EGTRRA added a level of confusion rarely seen in advanced planning. For instance, between now and 2011 the federal estate tax is scheduled to decrease, disappear and then spring back to life. According to a Wall Street Journal article dated May 11, 2005, the “…current estate tax law puts estate-tax planners in an impossible situation…”. With such uncertainty, some potentially damaging estate planning myths have surfaced. These financial “urban legends” stand in the way of prudent estate planning The Law Firm of Steven F. Bliss Esq.
Myth. Death taxes were repealed in 2005.
Sometimes, state and federal tax laws overlap. Most people are aware of the federal estate tax, but many people do not realize that most states impose an estate inheritance tax that is paid in addition to the federal estate tax. Prior to 2005, the majority of states tied their estate taxes to the federal estate tax through an esoteric federal credit known as the “state death tax credit.” In 2005, the credit was repealed leading many people to think that all state estate taxes were eliminated.
The reality is that the status of state estate taxes depends on where you reside. In 2005, the state death tax credit was repealed and became a deduction on the federal estate tax return. The majority of states saw their estate taxes eliminated with a resulting loss of revenue. Faced with the proposition of losing tax revenues, many states “decoupled” their estate taxes from the federal system and set up free standing state estate taxes. As of January 2008, 17 of the 37 so-called “credit tax” states had decoupled.
Keep in mind, the states that currently have no state death tax could institute new taxes. Also, because of some quirks in the federal tax laws, starting in 2011 a significant number of states are scheduled to have their death taxes reinstated. Therefore, it is a good idea to stay abreast of the legislative environment in your state and at the federal level to determine whether changes are on the horizon. Many other states have their own estate and/or inheritance taxes that operate independently from the federal system. Most states use exemption amounts below the federal exemption amount which could result in state death taxes at the first death for a married couple.
Let’s review an example to better understand what these changes mean. If you live in California, Florida, or Texas there is currently no state death tax (but the federal estate tax still applies). On the other hand, people who live in Pennsylvania have a state inheritance and estate tax. If a person uses a will that includes a family trust (often referred to as a “bypass” or “credit” trust), it would create a state estate tax at the death of the first spouse. Pennsylvania is just an example. Different states use different exemption amounts and tax rates vary, but the concept is the same in some states there may be a need for cash at the first death, that did not exist prior to 2005. Life insurance often plays a critical role in providing tax liquidity. In some states, as long as the named beneficiary is not the insured’s estate, life insurance death benefits are exempt from state estate taxes. Check to see if your state offers this tax break or contact us for assistance.
Myth. Life insurance for tax liquidity is not necessary if federal estate tax is repealed.
Some people mistakenly believe that the repeal of the federal estate tax (however unlikely that may be) would render life insurance unnecessary to cover post death taxes.
The reality is that under current tax laws, the federal estate tax is replaced in 2010 by a capital gains tax to be paid by heirs. The heirs will inherit property with a carryover tax basis, instead of with a stepped-up basis. The heirs will be responsible for paying capital gains taxes when they sell the property. Under the capital gains regime, there will be a premium on record keeping, because if a taxpayer cannot prove the tax basis, then the IRS presumes that the basis is zero resulting in the entire sales amount subjected to capital gains taxes.
Let’s look at an example of the capital gains tax regime. Suppose a married couple owned a business valued at $6 million. If the business is sold pursuant to a buy-sell agreement after the death of a spouse, a capital gains tax of $442,000 would be due. In some cases, the taxes due under the capital gains regime could exceed the taxes due under the current estate tax system as we shall see shortly.
Now, let’s use the same example and assume the taxpayer is single. Here, the capital gains tax exposure would nearly triple, exceeding $1.2 million. This amount exceeds what would have been due under the 2009 estate tax. This is an example where the estate tax would have been less costly than the capital gains tax from a cost perspective. Remember, these examples do not take into account the impact of state estate taxes that typically range from 5 to 20% where applicable.