Everyone Has an Estate
For purposes of understanding the federal estate tax, we must first examine the definition of “estate” provided by the U.S. Internal Revenue Code.
“Estate” Includes Property Owned at Death
Contrary to what seems to be popular belief, every person has an “estate”, whether it’s worth $1 or $100 billion. An individual’s estate does not only include a person’s “real estate” or just one’s large country estate. In our context here, we’re also not referring to one’s “probate estate” either.
Instead, your estate includes all the property over which you have some interest at the time of your death (see 26 U.S.C. § 2033). Not to be cute, but here are several examples that further illustrate this point:
- Mr. Bill owns 520 million shares of M Corporation personally, which is worth about $25 per share, and owns no real estate. His estate is therefore valued at about $13 billion.
- Ms. Jeanette owns a $500,000 house with a $350,000 mortgage, has $200,000 in a retirement plan, and owns $1 million of term life insurance on her husband’s life. Her father is dying, and she anticipates receiving $650,000 from his estate in 2012. Her estate is currently valued at $350,000, but could potentially grow to over $2 million if her husband predeceases her.
- Janey, a 2-year-old girl, has received $100 in cash gifts from her parents and grandparents during her lifetime, has stuffed animals and games valued at about $50 total, and has $3.67 in her piggy bank. She therefore has about $153.67 in her estate (OK, maybe this part is cute).
“Estate” Also Includes Certain Unowned Property
While the preceding sounds a lot like a calculation of your net worth, it is important to understand that your estate can also include certain property that you don’t own at your death (remember, the Internal Revenue Code definition refers to one’s “interest” in property and not “ownership”). Here are some examples of such property:
- Certain gifts made within 3 years of the decedent’s death;
- Certain property held by the decedent for life only (aka a “life estate”);
- Certain annuities, including those with income still payable after the decedent’s death;
- Property over which the decedent had a “power of appointment”;
- Life insurance owned by the decedent regardless of who is named beneficiary;
- Life insurance payable to the decedent’s estate;
- Certain disclaimed property.
To illustrate, if Ms. Jeanette from above also owned a $1 million term life insurance policy on her own life, then that $1 million face value would also be included in her estate, even though she never had access to these funds (hint: this error is avoidable — MA attorney Jennifer Deland elaborates in the comments below). If Ms. Jeanette dies after her husband, her estate could be valued at over $3 million.
For further definitions and coverage of what is included in one’s estate, start first with 26 U.S.C. §§ 2031 to 2046.
Federal Estate Taxes
Under U.S. tax law, upon the death of any U.S. citizen or resident, an estate tax is charged on the transfer of that person’s estate to beneficiaries or heirs. See 26 U.S.C. § 2001(a).
However, a credit is applied to the estate of every decedent against the tax. See 26 U.S.C. § 2010(a). The following bulletpoints discuss federal estate taxes for a person dying in 2012 only:
- The first $5,120,000 of any individual’s estate will be exempt from estate taxes. An estate tax of up to 35% is charged only on the excess of this exemption.
- For example, if a person dies with a $5 million estate, he/she will owe no estate taxes.
- On the other hand, a person with a $6 million estate exceeds the $5.12 million credit by $880,000. That $880,000 will be charged a tax of up to 35%, which would be approximately $308,000.
- From our examples above (assuming no other estate planning):
- Mr. Bill would be taxed on the excess of $13 billion over $5.12 million. His estate tax bill would be about $4.45 billion.
- Ms. Jeanette, Janey, and anyone else with an overall estate of less than $5.12 million would not owe any estate tax.
This effectively results in very few citizens or residents owing any estate tax because most simply do not or will not have a $5.12 million estate.
So Why Worry About It?
Because if Congress does not agree by the end of 2012, the estate tax is set to revert to pre-2001 levels. As of this date, estate tax rates for 2013 and beyond are set to increase to a maximum of 55% (up from 35% in 2011 and 2012), and only the first $1 million of one’s estate (down from $5.12 million in 2012 and $5 million in 2011) would be exempt.
To anyone like Ms. Jeanette from above, this should capture your attention. Anyone whose estate is valued under $1 million now, but could grow over time and circumstance to well over $1 million, could have an unexpected estate tax in the future.
For instance, if Ms. Jeanette died in 2013 with $3 million in her estate, she could have a $1.1 million estate tax bill. Ironically, this tax would greatly exceed the $308,000 estate tax bill of a person who died in 2012 with $6 million, as discussed above.
Be sure to look closely at how your home (once it’s paid off), retirement plan assets, potential inheritance and life insurance would impact the size of your net worth and estate.
Should You Wait to Plan?
There are many examples here and throughout the inter-tubes on ways that estate planning can reduce an estate tax bill. By the way, does all of this mean you should wait until estate taxes are set for 2013 and beyond before planning your estate?
No, because estate planning encompasses much more than just estate tax planning! More on this point in future posts.
Otherwise, I hope this brief discussion is of some help to you.
Happy Holidays to you and yours!
- Things Change: Review Your Estate Planning Documents Regularly! (altmanassociates.com)
- Estate Tax-Saving Tips for the Average Taxpayer (lawprofessors.typepad.com)
- Three Basic Ways to Reduce or Eliminate Estate Tax (lawprofessors.typepad.com)