What Is the Estate Tax?
Estate tax is a specific federal law that, if applicable, determines at time of death, a certain amount of tax owed on any estate valued above the current year’s exemption ($12.06 million for 2022 and 24.12 million for couples). Most states do not have an estate tax, but regardless, given its high exemption amount, most Americans will never encounter it because if your estate is worth less than that in 2022, you won’t owe any estate tax.
Residents subject to estate tax include states such as Hawaii, Washington, Oregon, Minnesota, Illinois, Vermont, Maine, New York, Massachusetts, Rhode Island, Connecticut, Maryland, and Washington, D.C. (exemption thresholds vary by state).
Thus, if your estate resides in one of these states and is valued above the exemption the state allows, your estate is exempt of $12.06 million (if in California) and can subtract this amount from its total worth. Anything above this amount (for 2022), will incur estate tax. So, as an example, if an estate has an $18 million value, it will only pay estate taxes on the $5,940,000 above the exemption. Read on to learn estate planning strategies to reduce estate taxes and if you have any questions, reach out to a knowledgeable Orange County estate planning attorney at Evolution Tax and Legal.
How to Reduce Estate Taxes: 10 Tips
Other than not residing in any of the states with estate tax, the following 5 tips will help to reduce any estate tax you might owe.
Set Up an Irrevocable Life Insurance Trust (ILIT)
Another great trust that offers a variety of tax benefits is an irrevocable life insurance trust (ILIT). This financial planning tool allows funds to be transferred into a life insurance trust which are used to pay premiums for one or more life insurance policies. Such policies could be:
- A term policy
- A whole life policy
- A second-to-die policy
And again, because it’s an irrevocable trust, funds transferred to the trust are tax-deductible in that tax year. At time of death, the trust inherits the life insurance proceeds, but not the estate. Assets distributed through the trust are not subject to estate taxes. Therefore, an ILIT possesses a great advantage in reducing state and federal taxes owed during life, and can further avoid estate taxes after death, while allowing the donor to control the timing and distribution of an inheritance in the trust.
Establish a Family Limited Partnership
Another estate planning tool is a family limited partnership which is available to families with business interests. It is specifically set up as a limited partnership (LP) or a limited liability company (LLC) and designed for family-owned holding companies. The advantages of a family limited partnership are:
- It minimizes income tax;
- It ensures continuity of ownership of a business (and other assets); and
- It limits liability for family partners.
Two classes of owners in the family limited partnership exist:
- The general partners, which are typically the ones who set up, own and manage the partnership; and
- Second-class owners, who are typically the children and grandchildren of the general partners and are limited partners or passive owners.
With respect to the general partners, assets are transferred into the partnership and then an interest or share in the partnership is gifted to family members. And since the shares can’t be sold to anyone other than a family member, it lacks marketability. So much so that the value of synch an interest can be discounted from 15% to 30% in value. That discount amount alone can sometimes make a difference between paying federal estate tax or not.
Another thing to note is that assets in the partnership are protected until they are distributed. Additionally, partners pay income tax on their share of income from the business of the family limited partnership. The family limited partnership is also free of inheritance tax and estate tax.
Lastly, when the general partners are ready to transfer control, they can decide who will receive their interest: a family member or trustee.
Set Up a Charitable Trust
Charitable transfers or gifts to charities upon death can be a great way to reduce the value of your estate and thereby reduce estate taxes. Moreover, a gift made by way of a charitable trust, may allow the donor to retain the right to use the gifted asset or income therefrom during the donor’s lifetime, while adding the benefit of an income tax deduction.
Fund a Qualified Personal Residence Trust
We have distinguished several trusts that can significantly benefit an estate. One trust specifically that can be used to transfer a home after the death of a spouse while allowing the second spouse to remain in the home until their death, is a qualified personal residence trust (QPRT) which permits both homeowners to put their home into trust for their children while still allowing them to continue to live in the home for a set number of years.
If the home increases in value during the lifetime of the parents, the amount of the increase will not be added to the home’s value when the home is gifted to the children. If the home is in an area that swiftly appreciates property values, this can be a win-win situation as this trust then reduces the amount of gift tax on the estate. A QPRT is not without risk, however. If the grantor (homeowners) die before the end of the trust, the tax savings for the trust beneficiaries is lost.
Move to a State Without Estate Taxes
As stated, most states do not have estate tax. Therefore, if you live in any of the following states (through 2022), you do not have to be concerned with reducing your tax liability:
- Alabama
- Alaska
- Arizona
- Arkansas
- California
- Colorado
- Delaware
- Florida
- Georgia
- Idaho
- Iowa
- Indiana
- Kansas
- Kentucky
- Louisiana
- Michigan
- Mississippi
- Missouri
- Montana
- Nebraska
- Nevada
- New Hampshire
- New Jersey
- New Mexico
- North Carolina
- North Dakota
- Ohio
- Oklahoma
- Pennsylvania
- South Carolina
- South Dakota
- Tennessee
- Texas
- Utah
- Virginia
- West Virginia
- Wisconsin
- Wyoming
However, it is important to note, there are some states on this list that do impose inheritance tax which is different from estate tax.
Who Has to Pay Estate Tax?
The estate itself pays estate tax. More specifically, the executor of the estate is responsible for filing and paying any taxes that are due on behalf of the estate and deductions such as mortgages, debts, administration costs, and the value of property passed on to surviving spouses or charities can all help the executor reduce the estate’s tax liability.
To sum it all up, as of 2022, an individual can leave $12.06 million to their heirs without paying any federal estate or gift tax. Note that the IRS determines the value of assets using the fair market value and not the original purchase price or acquisition value.
Reduce Your Estate Taxes With Evolution Tax and Legal
As you can see, there are a variety of financial planning tools to reduce the tax liability of your estate. Maintaining wealth beyond your lifetime is achievable but requires a sophisticated and detailed understanding of the many estate planning vehicles which allow for generational wealth. At Evolution Tax & Legal, we are committed to providing the best estate planning tools that cater to your specific situation. Let us be that driving source to help maximize the amount of your estate to benefit those you love.