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Understanding the Federal Estate Tax system is extremely important to know about for every citizen. “Inheritance Tax” is not a reference to “Estate Tax” –– however, both terms are often used interchangeably. This is because both fall under the (somewhat morbid) umbrella term “Death Taxes”. An Estate Tax is levied against a person’s estate (the “transferor”) upon their passing.  An Inheritance Tax is levied against an individual (the “transferee”) receiving a distribution from a deceased person. There is no Inheritance Tax in California.

While it is difficult to think about emotionally, estate planning is important.  A comprehensive and well-thought-out estate plan determines what happens to the assets of all individuals after they pass away. Estate is used to describe the fair market value of a deceased person’s total assets and is taxed accordingly at the time of collection. Rules of the Federal Estate Tax are changed every year and are based on numerous factors, such as inflation rate, government policies, new tax deductions or credits, and fair market value of the estate at the time of valuation. The IRS allows unique exceptions to the outlined rules. The exceptions are reevaluated annually and can be changed.

Reviewing rule changes and estate plans frequently is important for ensuring exemptions are fully utilized. Since rates, figures and exemption can change every year, one’s estate that once fell below the taxable threshold, could become taxable the following year. This possibility reflects the reality and importance of an annual estate plan review –– creating comfort and security for one’s assets and their family upon their death.

A Brief Background

Instances of asset taxation upon the death of US citizens are found as early as 300 years ago. Methods of implementing this tax have changed multiple times––most recently in 2018, with the implementation of the Tax Cuts and Jobs Act (TCJA). Currently still in effect, the TCJA indexes estate tax rates for inflation each year, as well as the exemption amount allowed –– which is how much of an estate’s value is not taxable before the tax rate is applied.

Before 2018, estate taxes were subjected to more volatility. For instance, in 2010, the Tax Relief Unemployment Insurance Reauthorization and Job Creation Act (TRUIRJCA) set the maximum estate tax rate at 35%. This act was implemented such that 35% would remain the maximum rate for estate taxation until December 31, 2012 –– after which the rate would become 55% in January 2013, and the new exemption amount would be $1 million.

In 2013, the American Taxpayer Relief Act (ATRA) was passed––changing the rules on how estates, gifts, and transfer taxes were structured permanently.

What to Know in 2020

As mentioned, the applicable rates and exemptions on estates change annually, and are indexed based on inflation. The estates of all US citizens are subject to federal estate taxation –– however, this depends on the valuation of the estate at the time of the owner’s death.

• The estate tax exemption amount for 2020, is $11.58 million and is subject to inflation adjustments each year until the law “sunsets” on December 31, 2025. That means on January 1, 2026, the federal estate tax exemption would sunset to the level of $5.49 million, plus an inflation index adjustment for the period from 2018 to 2025.
• The applied tax rate on estates valued over $11.58 million after deductions and credits will depend on the valuation of each estate, and how far over the exemption threshold it is valued.
• For estates with a valuation larger than $11.58 million after deductions and credits, estate tax brackets and their rates can be found at www.irs.gov.
• An estate with a valuation less than $11.58 million, after deductions and credits, may pass to its heirs and/or beneficiaries without federal estate taxation.
• The date of estate valuation is considered to be the date of the estate owner’s death.
• If an estate is expected to lose value, the estate owner/executor may request a six-month alternative valuation date using Form 706.

Most estates will not be subject to federal estate tax with the $11.58 million exemption amount. However, if an estate is currently valued at or above this amount, estate planning and restructure is even more important.

The federal government allows gifts of money––and property valued up to $15,000, non-taxable –– to be given without reporting to the IRS each year. This is known as the “annual exclusion amount” and is also subject to inflation index adjustments. Gifts exceeding this amount must be reported to the IRS, but are still considered non-taxable as long as they are within IRS rules and regulations. These are options many owners of estates exceeding the exemption amount utilize in an attempt to decrease the taxable amount of their estate.

Working with a professional estate planner is by far the best way to ensure proper asset allocation, and that the maximum amount of an estate possible will be utilized as desired.

Requirements for a Taxable Estate
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If an estate’s gross value exceeds the exemption amount for the year, such as the $11.58 million amount for 2020, Form 706 must be filed with the IRS and submitted alongside payment at the same time. The requirement –– if not filing for an alternative valuation date –– is nine months after the descendant’s death.

If an extension is needed, Form 4786 is the appropriate application used to determine eligibility for an extension by the IRS. However, if an extension on an estate tax filing is applied, the payment will begin to accrue interest after the initial nine-month requirement. This among many other reasons is why the expertise of a professional estate planner is beneficial.

The Unlimited Marital Deduction

Among the many deductions applicable to estate taxes is the Unlimited Marital Deduction. This enables a first spouse to die to claim a deduction on everything transferred to their surviving spouse. It should be noted that there are restrictions if the surviving spouse is not an United States citizen.

What is “Portability”?

Portability provides the option for a spouse to transfer any unused exemption amount of the first spouse to die to a surviving spouse, for use as an exemption on their estate at their time of death.

For example, if Spouse A is leaving their estate to Spouse B –– and the estate is valued at a total of $5 million (after deductions and credits) –– the $6.58 million difference in Spouse A’s estate that fell below the 2020 exemption amount, would then be added to Spouse B’s overall exemption allowance at the time of their death thereby allowing the surviving spouse to “bank” the unused exemption of the first to die for future use.  Therefore, Spouse B’s exemption amount at their time of death would be $6.58 million, plus whatever exemption that they had at the time of their death assuming that they had not remarried.

Additionally, it is important to know that Form 706 must still be filed by the estate’s executor/administrator, if portability is elected –– notifying the IRS that there is intention to elect the portability option.

In Conclusion

By planning and preparing for the distribution of an estate, one can make certain their estate assets will be utilized as intended upon their death. While often uncomfortable to discuss, estate planning is extremely important, as obligations such as Federal Estate Taxes are sometimes owed to the IRS.

Being knowledgeable and working with a professional estate planner can mitigate uncertainty, as well as risk of mismanaged assets after one’s passing.

If you have any questions or would like more information, please don’t hesitate to call (877-585-1558), email us or register to one of our free workshops or webinars.

By Christopher E. Botti

Photo credit: Olga Delawrence