Following the 1981 amendment to the federal estate tax law which created an “Unlimited Marital Deduction,” death taxes became “second death taxes.” No longer did most families have to worry about death tax at the death of one spouse with a spouse surviving. It was a tax on the children! The other side of this story is that with proper planning, parents can double the amount they pass tax free to their children. They can often greatly reduce or even eliminate this “tax on the children.”
The current federal estate tax exemption is $5 million.* Estates of less than $5 million will not produce federal estate tax. The often missed “other side of the story” is the Tennessee inheritance tax; however, this tax is set to expire in 2016. Currently the Tennessee exemption is $1 million. The exemption increased from $1,000,000 to $1.25 million in 2013, $2 million in 2014, and $5 million in 2015. The tax is repealed on January 1, 2016.
To the extent that an estate exceeds the Tennessee inheritance tax exemption, taxes of approximately nine cents on the dollar will be imposed. To the extent that an estate exceeds $5 million, combined federal estate tax and Tennessee inheritance tax will exceed 50 cents on the dollar.
For residents of Arkansas and Mississippi where there is no current inheritance tax, the federal estate tax on Arkansas and Mississippi estates in excess of $5 million will be approximately 40 cents on the dollar.
Avoiding Death Tax with a Family Trust
The most significant estate planning tool available to all married couples is a trust that is commonly referred to as a “Family Trust.” The basic idea behind a Family Trust is to allow both spouses to use their respective estate tax exemptions and double the assets that can be left to children free of death taxes.
For Tennessee residents, because of the difference between the federal and Tennessee exemption amounts, a Family Trust may need to be divided into two separate trusts: a Family Trust and a Tennessee Trust.
Patricia (age 50) and Fred (age 52) have assets, including life insurance, totaling $8 million. In the event of the death of either spouse, there will be no estate taxes to pay if the entire estate is payable to the spouse who is a U.S. citizen. At the death of the survivor when the assets pass to the children, the federal estate tax could exceed $1 million. If Patricia and Fred are Tennessee residents, additional taxes may be due to the State of Tennessee which will greatly increase total tax liabilities. Most of the tax can be avoided with a Family Trust.
Uncertainty and Choices
There are a number of uncertainties. Patricia and Fred do not know when they will die. They do not know whether Congress will modify the law before their deaths. They do not know what their assets will be worth at the time of death.
What Patricia and Fred know is that without adequate planning, a substantial portion of their estate may be lost in the form of death taxes.
The Family Trust
The textbook answer to the problem faced by Patricia and Fred is the utilization of a Family Trust in their Will or in their Living Trust. The use of a Family Trust as an estate planning vehicle is extremely common. Properly used, the Family Trust can double the amount that can pass tax free for federal estate tax and state inheritance tax purposes.
In an $8 million estate, all federal estate taxes should be eliminated. Tennessee inheritance tax liabilities will be substantially reduced, probably by $100,000.
The Family Trust, created in the Will or Living Trust, provides for Patricia for her lifetime. She may receive all of the income or that which is needed for her reasonable health, support and care and to maintain her accustomed manner of living. She may receive principal for the same purposes. It is possible that income or principal may be distributed with Patricia’s approval to the children or grandchildren. Patricia can determine how the assets are to be divided and distributed at her later death. What is important about the Family Trust is that, properly structured, the assets in the Family Trust can pass totally estate tax free and at least partially Tennessee inheritance tax free at Patricia’s later death.
The Trust Continues or Terminates
Following the death of the surviving spouse, most likely Patricia, the Family Trust can terminate with the assets being distributed to the children and/or grandchildren as Fred and Patricia direct. In the alternative, the trust can continue for the benefit of the children until they reach an age which Patricia and Fred feel is an appropriate age for assets to be distributed to the children. If appropriate, the trust can continue for the benefit of the children for their entire lifetime. This type of trust is referred to as a Generation Skipping Trust. It can reduce or even eliminate the death tax at the children’s later death. The Family Trust assets are generally protected from death taxes, but the trust also protects the assets from claims of a future or former spouse, claims of creditors, and assures that the assets are distributed to or for the benefit of the family in the manner that you direct.
The primary purpose of the utilization of a Family Trust is to minimize death taxes. Properly structured, a Family Trust allows us to double the amount that can pass tax free for Tennessee inheritance tax purposes and double the amount that can pass tax free for federal estate tax purposes from $5 million to $10 million.
In order to make the trust work, it is often necessary to adjust the ownership of assets between husband and wife, and change beneficiary designations on life insurance and retirement plan assets. The structure and type of assets sometimes makes it impossible to fully maximize benefits. However, in most every case, the utilization of a Family Trust will substantially reduce the death tax liability, even if taxes cannot be eliminated entirely.
Family Trusts come in many forms and require multiple decisions. The structure of a trust that best suits one family may not suit the next. With proper counsel and advice of an experienced estate planning attorney, clients are able to select options which are best for their family with minimum thought and deliberation.
* The $5 million exemption is indexed for inflation. The exemption for 2014 is $5.34 million. Five million is used in this article for convenience purposes.
A. Stephen McDaniel (2014)