In the overwhelming majority of Texas estates on which the attorneys of Ford+Bergner provides advice, the Testators are primarily concerned about two issues: 1) dividing and distributing assets at death, and 2) reducing or eliminating taxes paid as a result of death.
Like the simple Wills, a Will with tax planning lays out the distribution of a Testator’s estate. However, unlike the simple Will, the Will including tax planning provisions is designed to reduce or eliminate estate tax consequences of individuals or married couples having larger estates.
The estate tax is a tax imposed by the federal government on transfer of wealth from one person to another. The tax is based on the fair market value of all of the assets owned by someone on the date of their death. This generally includes homes, bank accounts, cars, stocks, bonds, life insurance, IRA’s, retirement accounts, etc.
However, every person in the United States enjoys a certain lifetime exemption from the estate tax. In 2001, Congress revamped the estate tax exemption so that it increases yearly between now and 2009. In 2006, the exemption amount is $2 million. In 2007, it increases to $2.5 million. In 2009, the exemption will be $3.5 million; then, in 2010, the estate tax is repealed completely. In tax years beginning in 2011, the estate tax exemption amount decreases to $1 million and stays at that level until some point in the future when Congress changes it.
In addition to the estate tax exemption, Congress allows married individuals to make gifts either during life or at death to their spouse without triggering any estate taxes. These gifts, instead, pass outright to the spouse and are later included in the spouse’s estate upon their death.
To aid in understanding some of the estate tax concepts and the related provisions included in a Will with tax planning, following is an illustration of a situation where tax planning may be necessary:
Husband and Wife are married with 2 children. At the time of Husband’s death in 2006, he and Wife have a combined estate of $6 million, half of which is considered to be Husband’s. Husband’s Will leaves everything outright to his Wife. Wife later dies in 2009 and leaves everything to the children equally.
When Husband dies in 2006, Wife is not going to be required to pay estate taxes because Husband left everything to Wife, and gifts to a spouse are not subject to estate taxes. In 2009, when Wife dies, however, her estate consists of the entire $6 million that she and Husband owned jointly. Because Wife receives an exemption of $3.5 million in 2009, the remaining $2.5 million in assets are going to be subject to estate taxes at Wife’s death.
Because Husband left everything to his Wife, he lost the use of his estate tax exemption.
In a situation like the one presented in the Illustration above, most couples would like to 1) leave all of the assets for use by the surviving spouse and 2) capture both spouses’ estate tax exemptions so that the maximum assets will be excluded from tax.
To do this, we utilize what is commonly referred to as a “Bypass Trust.” Created in your Will, the Bypass Trust is designed to reduce or eliminate estate taxes while still providing the use of all of the assets for the surviving spouse. Assuming that Husband dies first, as in the Illustration above, Husband’s Will would provide that an amount equal to his estate tax exemption amount would be placed into Trust for the benefit of Wife for her lifetime, and Husband would appoint Wife as the trustee of the Trust. It would further provide that upon Wife’s death, the remainder of the Trust would be divided equally between their children (or in any manner Husband deemed appropriate).
When the assets are placed into the Trust, Wife has the use of the assets for her lifetime, and as the trustee of the Trust, she has the ability to decide when it is appropriate for her to use the assets. However, whatever assets are left in the Trust at Wife’s death are passed to the children without paying any estate taxes.
Using the same facts as the last Illustration, but instead of leaving the assets outright to Wife, Husband includes a Bypass Trust in his Will. What portion of the Estate is taxable at Wife’s death?
When Husband dies in 2006, his exemption amount of $2 million is placed into the Bypass Trust for Wife’s benefit. The remaining $1 million of Husband’s assets are passed outright to Wife. When Wife later dies in 2009, her estate consists of the $3 million that she had prior to Husband’s death plus the $1 million that Husband left to her outright (the monies held in the Trust are not counted as part of Wife’s estate). Wife’s combined $4 million estate is offset by her $3.5 million exemption in 2009.
In the first Illustration, $2.5 million of Wife’s estate was subject to estate taxes. In the second Illustration, only $500,000 of Wife’s estate was subject to estate taxes. By using the Bypass Trust, Husband and Wife were able to pass $5.5 million tax-free to their children, instead of only $3.5 million when Husband left all of his assets outright to Wife. This is a huge difference.