For most people, taxation is a small factor when inheritances are being distributed. There are no regular income taxes to pay on may assets, and if you inherit appreciated assets, you get a step-up in basis. This means that for capital gains purposes, the value of the assets would be equal to the date the original owner died, even if they appreciated considerably during the life of the person who left you the inheritance.
This being said, high net worth individuals do have to be concerned about the potential impact of the federal estate tax, which carries a 40 percent maximum rate. There is an estate tax credit or exclusion, and this is the amount that can be transferred before the estate tax would become applicable. Since it is relatively high, most people don’t have to worry about the death tax. At the time of this writing in 2020, the estate tax exclusion is $11.58 million.
The exclusion is allotted to each individual taxpayer. As a result, if you are married, you and your spouse would have a combined $23.16 million, and the exclusion is portable. This means that a surviving spouse would have two exclusions to utilize.
Plus, speaking of spouses, there is an unlimited marital deduction. You can use this to leave any amount of money and/or property to your spouse free of the estate tax, as long as your spouse is a citizen of the United States.
We should point out the fact that there are a number of states in the union that have state-level estate taxes. Our practice is in the state of Kansas or Missouri, and there is no estate tax in our state, but you can face exposure if you own property in a state that does have its own state-level estate tax.
There are also a handful of states that impose inheritance taxes, and there is a difference between an estate tax and inheritance tax. An estate tax is imposed on the taxable portion of the entirety of the estate before it is transferred to the heirs. On the other hand, an inheritance tax is levied on transfers to each individual nonexempt inheritor.
The term “nonexempt” is quite operative here, because in the states that have inheritance taxes, close relatives are typically exempt. Once again, we are fortunate as residents of Kansas and Missouri, because there is no state-level inheritance tax to contend with here.
Federal Gift Tax
It would make sense to consider lifetime gift giving as a way to get around the federal estate tax if you are faced with exposure. This used to be possible shortly after the enactment of the estate tax in 1916. However, some legislators endeavored to close this loophole, and a gift tax was put into place in 1924. It was repealed a couple of years later, but it came back for good in 1932.
The estate tax and the gift tax are unified under the tax code. This means that the $11.58 million exclusion is a unified lifetime exclusion that encompasses lifetime gifts along with the value of the estate that will be passed along to your heirs after you are gone.
In addition to this unified lifetime exclusion, there is an annual gift tax exclusion. The first $15,000 that you give to any number of different recipients can be transferred free of the gift tax, and you would not be using any of your lifetime exclusion to give these tax-free gifts.
Now that we have set the stage with the necessary background information, we can address the specific subject that serves as the title of this post. There are a number of different types of irrevocable trusts that can be utilized to mitigate your exposure to the estate tax if it is a factor for you. One of them is the generation-skipping trust.
To provide a simple explanation, you convey assets into the trust, and your grandchildren would be the beneficiaries. However, the assets would remain in the trust during the lives of your children. They would be able to benefit from assets that are contained in the trust, and after they pass, the grandchildren would assume ownership of the remaining resources.
The estate tax could be applicable then, but there would be just one round of taxation instead of two. Other estate tax asset protection trusts include grantor retained annuity trusts, qualified personal residence trusts, irrevocable life insurance trusts, charitable remainder trusts, and charitable lead trusts.
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