The Federal Estate Tax in 2011: "I'll be back" (Part 1)

For persons dying in 2010, the good news (at least for now) is that there currently is no Federal Estate Tax. Thanks to a 2001 law enacted by Congress, the decades old estate tax was slowly phased out of existence.

However, that 2001 Act contained a sunset provision that expires on December 31, 2010. The Terminator's famous line is probably an appropriate quote to describe what will happen with the Federal Estate Tax on January 1, 2011 if Congress continues in its stalemate on legislation on the topic. That's really bad news for individuals and married couples that have a combined wealth in excess of $1 million and have not carefully reviewed their estate plan recently. Absent action by Congress, on January 1, 2011, the estate tax rates will range from an eye-popping 37% (the lowest rate) and go up to an incredible 55%.

However, the good news is that with proper planning, you can minimize (and sometimes even eliminate) the effect of this tax. This can save tens of thousands, maybe even hundreds of thousands, of dollars in taxes.

In the coming weeks, I hope to provide a multi-part series on the importance of this legislative development to stress just how important this is, and how important it is to discuss this development with your estate planning attorney so that you and your family can determine what you can do to avoid, or at least minimize, this tax.

I. What is the Federal Estate Tax?

The Federal Estate Tax is a tax that the federal government levies upon each and every asset owned by an individual citizen that dies. This tax applies to every asset that is owned by the deceased individual (referred to in legal and tax jargon as the "decedent"). Even if the decedent owned only a partial interest, the decedent's partial interest is valued and included in this tax calculation.

Many people have the misconception that if you plan your estate to avoid probate, you avoid the estate tax. This is completely false. The estate tax applies to every asset owned by the decedent at the time of his or her death, regardless of whether or not the asset is included in the decedent's probate estate, a trust owned/controlled by a decedent (although certain types of trusts may be used to bypass the estate tax and will be discussed in a future part), or is left to a beneficiary by way of a beneficiary designation.

The estate tax is basically calculated by adding up the fair market value of all of the decedent's assets at the time of his or her death. Certain deductions may be taken from that total. The remaining amount, after deductions, is taxed. As indicated before, if Congress takes no action, the tax rate percentage that is applied to this number is somewhere between 37% and 55% depending on the size of the estate. The larger the estate, the larger the tax rate.

The Federal Estate Tax includes certain tax credits which can also reduce the amount of the estate tax. The most important credit is the "unified credit." Since 2001, the unified credit amount was gradually increased so that more and more estates were exempted from the Federal Estate Tax until 2010 when Federal Estate Tax disappeared. On January 1, 2011, absent Congressional action, the unified credit will return to the 2001 credit amount. This means that the unified credit will shelter only $1 million from federal estate taxation.

II. What assets are included in the estate tax calculation?

In short? Everything!

*Bank accounts (including checking, savings, money market, certificates of deposit)
*Stocks and bonds (including United States Savings Bonds and municipal bonds of all types)
*Mutual funds
*Annuities
*Life Insurance policies (includes the death benefit amount and accrued interest and dividends regardless of whether the policy is a term policy, universal life, or other form of life insurance policy)
*Accidental Death policies
*Real estate (including your home, vacation home, timeshare interest, investment property, or vacant land)
*Retirement accounts (including Roth IRA's, traditional IRA's, SEP's, SIMPLE's, 401k, Keough, and all other employer provided retirement account benefits)
*Tangible personal property (including vehicles, boats, trailers, campers, collectibles, artwork, cash on hand, and household contents)
*Family Business / Farm Interests (including close corporation interests, farms, partnership interests, or other forms of small business ownership and investment interests)

If the value of all these various types of assets added together is more than $1 million, and Congress takes no action to address the Federal Estate Tax, you need to evaluate your exposure to this tax immediately by consulting with an attorney experienced in estate tax planning.

III. What if I just give it away to my beneficiaries before I die?

Congress already thought of that loophole. That is why there is not only an estate tax, but also a gift tax that provides for comparable tax rates as the estate tax. If you give someone else (other than your spouse or a charity) more than the annual gift tax exclusion (2010's annual gift tax exclusion is $13,000 per donee), you must pay a tax on that gift.

However, in the next installment, we will discuss how gifting strategies during an individual's lifetime can help that individual significantly minimize estate taxes, as well as how married couples should take full advantage of both the husband's unified credit and the wife's unified credit rather than the natural inclination by couples to waste one of their unified credits.