Reducing the Cost of Dying
There are two death taxes which may impact your estate when you die the Pennsylvania Inheritance Tax and the federal estate tax.
The Pennsylvania Inheritance Tax
The Pennsylvania inheritance tax is a tax upon the privilege of inheriting property. Generally, all property owned by a decedent at death, which passes by will, intestacy or by operation of law, is subject to the inheritance tax. Generally, valuation is based on the fair market value as of the decedent’s date of death. Funeral expenses, administrative costs, and debts owed by the decedent at the time of death are allowed as deductions against the inheritance tax liability. The inheritance tax return, together with payment of the tax, is due no later than nine months after the decedent’s date of death.
Jointly held property is taxed based on the pro rata ownership of the decedent, i.e., if there are two joint tenants 50% is taxable if there are three 1/3 of the value of the jointly held property would be taxable. Transfers to charitable organizations, exempt institutions and government entities, as well as transfers qualified family-owned business interests to or for the benefit of members of the same family are exempt from inheritance tax.
There is no gift tax in Pennsylvania. However, transfers made within one year of the death of the transferor are subject to inheritance tax to the extent that the value at the time of the transfer or transfers in the aggregate to or for the benefit of the transferee exceeds three thousand dollars ($3,000) during any calendar year.
There are two death taxes which may impact your estate when you die the Pennsylvania Inheritance Tax and the federal estate tax.
The Rate of Tax
The rate of tax depends on the relationship of the decedent to the person receiving a taxable transfer from the estate:
− Any asset passing to a decedent’s spouse is taxed at 0%;
− Transfers from the estate of a child age 21 or younger to the child’s natural parent, adoptive parent or stepparent are subject to a zero-tax rate;
− The lineal tax rate is 4.5% and is applicable for transfers to a grandfather, grandmother, father, mother, children, un-remarried wife and husband or widower of a child, and lineal descendants;
− The sibling tax rate is 12%, and is applicable for transfers to brothers or half-brothers, sisters or half-sisters; persons having at least one parent in common with the decedent, either by blood or by adoption. Transfers between step-siblings are subject to tax at the collateral rate;
− The collateral tax rate is 15% and is applicable for transfers to all other beneficiaries. This includes, but is not limited to transfers to or for the benefit of, aunts, uncles, cousins, nieces, nephews, friends, sister-in-law, brother-in-law, pets and organizations not classified as a charity;
The Federal Estate Tax
The federal estate tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your "Gross Estate." The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests and other assets.
Who Is Subject to the Federal Estate Tax?
The estates of each and every U.S. citizen are subject to the federal estate tax, but very few estates actually have to actually pay it because of the exemption. The Internal Revenue Code effectively gives each U.S. citizen this "coupon" to apply against the value of their estates.
The exemption was $3.5 million in 2009, increasing to $5 million in 2010 and 2011. It went up to $5.12 million in 2012, then to $5.25 million in 2013. By 2014, it was up to $5.34 million, then it increased again to $5.43 million in 2015 and to $5.45 million in 2016 before reaching $5.49 million in 2017.
The exemption hiked up to $11.4 million in 2019. This means that only estates whose values exceed $11.4 million after deductions are made and credits are taken are subject to the federal estate tax on the balance. An estate will pass to its heirs and beneficiaries free from federal estate taxes if its net value after being reduced by allowable estate tax credits and deductions does not exceed $11.4 million in 2019.
The Unlimited Marital Deduction
One of the most significant deductions for the estate of a married decedent is the unlimited marital deduction. Remember, the estate tax is based on an estate's value after all available deductions and credits have whittled it down. The unlimited marital deduction allows a decedent to take a deduction for everything transferred to the surviving spouse at death. An estate could escape taxation entirely in this circumstance, simply because a decedent was married and left everything he owned to his spouse. Marital assets would be subject to the estate tax when the surviving spouse dies unless that spouse has remarried and again passes the property to the current spouse, but this would effectively mean disinheriting the couple's children, if any.
Estate Tax "Portability"
The Internal Revenue Code also provides for portability of the estate tax exemption between married couples. The portability provision allows the estate of one spouse to shift any unused federal estate tax exemption to the surviving spouse for use at the time of the surviving spouse's own death. For example, Joe might have left an estate worth $10 million. After applying the 2019 estate tax exemption of $11.4 million, $1.4 million of the exemption would be left over. Joe's spouse Mary can accept that remaining $1.4 million exemption from Joe's estate and add it to her own exemption. Now Mary can shelter $12.8 million of her estate, or $1.4 million more than whatever the estate tax exemption is at the time of her death. A federal estate tax return must be filed if the executor of the estate wants to give the portability bump to the surviving spouse, even if the decedent's estate doesn't owe a tax because its value doesn't exceed the exemption amount. The estate tax return would simply indicate that the portability option is being exercised, alerting the IRS to this fact.
What Happens When an Estate Is Taxable?
An estate must file a federal estate tax return, Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return, when a gross estate exceeds the federal estate tax exemption for the year of the decedent's death.
What Can You do to Reduce the Impact of the Federal Estate Tax on Your Estate?
If your estate is in the range where you are potentially exposed to the federal estate tax, the estate attorneys at Gibson&Perkins, PC can help. Here are some ideas:
Federal law lets you give up to $15,000 ($30,000 if married) to as many people as you wish each year. So if you give $15,000 to each of your two children and five grandchildren, you will reduce your estate by $105,000 a year (7 x $15,000), $210,000 if your spouse joins you. (This amount is tied to inflation and may increase every few years.) State laws may differ.
If you give more than this, the excess will be considered a taxable gift and will be applied to your "unified" gift and estate tax exemption. (If you use it while you are living, it's considered a gift tax exemption; if you use it after you die, it's an estate tax exemption.) Charitable gifts are still unlimited. So are gifts for tuition and medical expenses if you give directly to the institution.
Remove Assets From Your Estate
One way to reduce estate taxes is to reduce the size of your estate before you die. So, spend some and enjoy it! Also, you probably know whom you want to have your assets after you die. If you can afford it, why not make some gifts now and save estate taxes? It can be very satisfying to see the results of your gifts, something you can't do if you wait until you die.Appreciating assets are best to give because any future appreciation will also be out of your estate. Gifted assets keep your cost basis (what you paid for them), so recipients may pay capital gains tax when they sell. But at 15% on assets held longer than 12 months, that would be less than estate taxes (35-55%) if you keep the assets until you die.
Irrevocable Life Insurance Trust (ILIT)
You can remove the value of your insurance from your estate by making an ILIT the owner of the policies. As long as you live three years after the transfer of an existing policy, the death benefits will not be included in your estate. Usually, the ILIT is also beneficiary of the policy, giving you the option of keeping the proceeds in the trust for years, with periodic distributions to your spouse, children and grandchildren. Proceeds kept in the trust are protected from irresponsible spending, creditors and even spouses.
Qualified Personal Residence Trust (QPRT)
A QPRT removes your home, a substantial asset, from your estate now, yet you can continue to live there. It allows you to transfer your home to a trust (QPRT) for a period of time, usually 10-15 years. During this time, you continue to live there. When the trust term is up, the home transfers to the trust beneficiaries, usually your children. If you wish to stay there longer, you may make arrangements to pay rent. If you die before the trust term ends, your home will be included in your estate, just as it would without a QPRT.
A QPRT "leverages" your estate tax exemption. Since your children will not receive the house until the trust ends, its value as a gift is reduced. For example, if the current value of your home is $250,000 and you put it in a QPRT for 15 years, its value for tax purposes could be as little as $75,000. That leaves much more of your exemption for other assets.
Grantor Retained Annuity Trust (GRAT) and Grantor Retained Unitrust (GRUT)
These are much like a QPRT. The main difference is that a GRAT or GRUT lets you transfer an income-producing asset (stock, real estate, business) to a trust for a set number of years, removing it from your estate -- and still receive the income. (If the income is a set amount, the trust is called a GRAT. If the income fluctuates, it's called a GRUT.)
When the trust ends, the asset will go to the beneficiaries of the trust. Since they will not receive it until then, the value of the gift is reduced. If you die before the trust ends, some or all of the asset may be in your estate.
Limited Liability Company (LLC) and Family Limited Partnership (FLP)
FLPs and LLCs let you reduce estate taxes by transferring assets like a family business, farm, real estate or stocks to your children now, and still keep some control. They can also protect the assets from future lawsuits and creditors.
Here's how they work. You and your spouse can set up an LLC or FLP and transfer assets to it. In exchange, you receive ownership interests. Though you have a fiduciary obligation to other owners, you control the LLC (as manager) or FLP (as general partner). You can give ownership interests to your children, which removes value from your taxable estate. These interests cannot be sold or transferred without your approval, and because there is no market for these interests, their value is often discounted. This lets you transfer the underlying assets to your children at a reduced value, without losing control.
Charitable Remainder Trust (CRT)
A CRT lets you convert a highly appreciated asset (like stocks or investment real estate) into a lifetime income without paying capital gains tax when the asset is sold. It also reduces your income and estate taxes, and lets you benefit a charity that has special meaning to you. With a CRT, you transfer the asset to an irrevocable trust. This removes it from your estate. You also get an immediate charitable income tax deduction. The trust then sells the asset at market value, paying no capital gains tax, and reinvests in income-producing assets. For the rest of your life, the trust pays you an income. Since the principal has not been reduced by capital gains tax, you can receive more income over your lifetime than if you had sold the asset yourself. After you die, the trust assets go to the charity you have chosen.
Charitable Lead Trust (CLT)
A CLT is just about the opposite of a CRT. You transfer an asset to the trust, which reduces the size of your estate and saves estate taxes. But instead of paying the income to you, the trust pays it to a charity for a set number of years or until you die. After the trust ends, the trust assets will go to your spouse, children or other beneficiaries.
Buy Life Insurance
Depending on your age and health, buying life insurance can be an inexpensive way to replace an asset given to charity and/or to pay any remaining estate taxes. The three-year rule mentioned earlier does not apply to new policies. But you should not be the owner of the policy -- that would increase your taxable estate and estate taxes. To keep the death benefits out of your estate, set up an ILIT and have the trustee purchase the policy for you.