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Understanding Estate and Gift Taxes
What are estate and gift taxes?
If you give someone money or property
during your life, you may be subject to federal gift
tax. The money and property you own when you die (your
estate) may be subject to federal estate tax. The amount
you can leave to your heirs without estate tax is known as the " Applicable
Exclusion Amount ".
The gift tax applies to transfers by gift. A gift is made
when you give property (including money), or the use of
or income from property, without expecting to receive something
of at least equal value in return. If you sell something
at less than its full value or if you make an interest-free
or reduced interest loan, you may be making a gift.
The general rule is that any gift is a taxable gift. However,
there are many exceptions to this rule. Generally, the
following gifts are NOT TAXABLE gifts:
- The first $11,000 you give someone during a calendar
year (the annual exclusion);
- Tuition or medical expenses that you pay for someone
(the education and medical exclusions);
- Gifts to your spouse;
- Gifts to a political organization for its use; and
- Gifts to charities.
If you are married, both you and your spouse can separately
give up to $11,000 to the same person each year without
making a taxable gift. Gift splitting allows married couples
to give up to $22,000 to a person annually without making
a taxable gift.
In addition, the Economic Growth and Tax Relief Reconciliation
Act of 2001 allows each taxpayer a lifetime tax exemption
of $1,000,000 that may be applied to taxable gifts. This
exemption amount will be effective in 2002 and remain indefinitely
at that level. The gift tax has not been repealed as in
the case of the estate tax, which will be repealed in 2010.
Estate tax may apply to your taxable estate at your death.
Your taxable estate is your gross estate less allowable
deductions. Your gross estate includes the value of all
property in which you had an interest at the time of death.
Your gross estate will also include:
- Life insurance proceeds payable to your estate or,
if you owned the policy, to your heirs;
- The value of certain annuities payable to your estate
or your heirs; and
- The value of certain property you transferred within
3 years prior to your death.
The allowable deductions used in determining your taxable
estate are:
- Funeral expenses paid out of your estate;
- Expenses for administration of your estate;
- Debts you owed at the time of death;
- The marital deduction ( value of the property that
passes to your surviving spouse); and
- Charitable contributions.
What is the Applicable Exclusion Amount?
Applying the Applicable Exclusion Amount allowed by the
Internal Revenue Code may reduce estate taxes. This amount
represents the value of property (less allowable deductions) that you may
give to your heirs free of estate tax. If your taxable
estate is worth less than the applicable exclusion amount
at the time of your death, then no estate tax will be due.
If your estate is worth more than the applicable exclusion
amount at the time of your death, then the total value
of the estate is reduced by the applicable exclusion amount,
and only the remaining balance is taxed. The current applicable
exclusion amounts are set forth below:
Year |
Applicable Exclusion
Amount |
2001 |
$675,000 |
2002 and 2003 |
$1,000,000 |
2004 and 2005 |
$1,500,000 |
2006, 2007
and 2008 |
$2,000,000 |
2009 |
$3,500,000 |
2010 |
repealed |
After 2010 |
$1,000,000 (unless repeal
is extended by congress) |
Married couples have a special deduction
- referred to as the "unlimited marital deduction" -
which allows them to defer estate taxes until the death
of both spouses. In other words, no tax will be due upon
the death of the first spouse regardless of the size
of the estate. However, if the combined estate of both
spouses is expected to exceed the applicable exclusion
amount, then it may not be a good idea to use the unlimited
marital deduction to defer taxes. The reason is that
each spouse is entitled to utilize the applicable exclusion
amount to protect assets from tax. As a result, a married
couple can protect an amount of property from estate
taxes equivalent to twice the amount of the applicable
exclusion. However, in most cases, special planning is
required to utilize both applicable exclusion amounts.
Using these definitions together, the amount of property subject to tax is determined using the following formulas:
Gross Estate - Allowable Deductions = Taxable Estate
Taxable Estate - Applicable Exclusion Amount = Amount Subject to Tax
The federal estate tax will be repealed in 2010. However,
it will automatically be reinstated in 2011 unless Congress
extends the repeal. Therefore, under current law, the estate
tax repeal will only be effective for persons dying in
2010.
How can I reduce my estate tax?
In very basic terms, there are five methods:
- For married couples, use both exemptions to double the amount of property protected from tax.
- Reduce the value of the taxable estate by making gifts of
property before death.
- Reduce the value of the taxable estate by using valuation discount techniques.
- Reduce the value of the taxable estate by making charitable contributions.
- Buy sufficient life insurance to pay the taxes due.
There are many variations for each
of these methods. Estate tax avoidance is a particularly
complex area, and requires special planning. Please contact us if you have questions.
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