Estate, Gift & Income Taxation

What tax considerations are involved in Estate Planning?

There are two basic forms of taxation that impact the estate planning process. First, there is income tax, which we all pay each year. Second, and less familiar, are transfer taxes that become due upon certain transfers of wealth.

What are Transfer Taxes?

Transfer taxes take many forms. In Illinois, there are currently five principal types of transfer taxes. These are the Federal Estate Tax, the Federal Gift Tax, the Federal Generation Skipping Tax, Illinois Inheritance Tax, and Illinois Generation Skipping Tax.

Transfer taxes are significant. In the year 2007, the maximum Federal transfer tax rate is 45%. Illinois transfer taxes are assessed over and above the Federal transfer taxes in an amount of between 6.4% and 16%. As a result, certain transfers could be taxed at an aggregate rate of over 50%.

Federal Gift Tax is assessed against asset transfers made during the taxpayer’s lifetime. The other four transfer taxes apply to asset transfers made upon death (“postmortem”), regardless of whether those transfers are made by Will, Trust or Contract. Examples of postmortem Contract transfers include joint tenancy, tenancy by the entirety, beneficiary designations, pay on death accounts, etc.

Transfer taxes are determined with reference to the value of the asset transferred (as opposed to the income earned on the asset) and are uniformly assessed against asset transfers with only a few exceptions. For estate planning purposes, the principal exceptions to the application of transfer taxes are the “Annual Exclusion” for Federal Gift Taxes and the “Applicable Exclusion Amount” for postmortem transfers.

The “Annual Exclusion” for Federal Gift Tax is tied to inflation. For the year 2007, the Annual Exclusion amount is $12,000. This means that in the year 2007, a single taxpayer can give up to the equivalent of $12,000 to each of an unlimited number of individuals without incurring any gift tax. Since the Annual Exclusion is tied to inflation, the amount of the exclusion is likely to increase over the next several years.

Just as there is a minimum threshold for the payment of Federal Gift Tax, there is a minimum threshold for the application of postmortem transfer taxes. The “Applicable Exclusion Amount” is a shorthand reference to the amount an individual may own before any postmortem transfer taxes will be assessed. In the year 2007, the Applicable Exclusion Amount is $2,000,000. This means that if a person dies in the year 2007 having less than $2,000,000 in her name, there might be no postmortem transfer tax due.

To further complicate matters, Federal and State transfer tax laws are in a state of flux. For example, the Applicable Exclusion Amount of $2,000,000 that applies to persons dying in 2007 and 2008 is scheduled to increase to $3,500,000 in the year 2009, be unlimited in the year 2010 and go down to $1,000,000 in the year 2011.

At first blush, most people do not consider themselves as having assets exceeding the Applicable Exclusion Amount. However, it is important to remember that this calculation includes Life Insurance and other assets that you might not ordinarily think of as part of your estate. It is also important to remember that in making this calculation, the assets owned by a married couple are often considered together upon the passing of the survivor. As a result, the relatively large number of taxable estates in Illinois might surprise you.

Estate Planning attorneys use a variety of Trusts, Wills and other tools to help reduce or eliminate the potentially devastating effects of transfer taxes. The more expertise your attorney has in this field, the greater the chances will be that your family will pay as little tax as possible during one of the most difficult times in their lives – the passing of a loved one.

What type of Income Tax planning should I be concerned with?

Income taxes continue to accrue after one’s death. In fact, the income tax brackets for decedent’s estates and trusts are condensed relative to your current individual income tax brackets. As a result, a decedent’s estate and/or trust may have greater Income Tax liabilities than an individual for the same level of income.

With the complexities created by the current popularity and usage of Income Tax deferred accounts, such as Individual Retirement Accounts (“IRAs”), 401(k)s and other qualified plans, Income Tax planning has become a mandatory component of Estate Planning.

However, Estate Planning is not the only area that requires Income Tax analysis. Virtually every financial transaction has a tax component that must be considered. Other types of transactions include: stock and bond transactions; executive compensation issues; alternative investment comparisons; and business investments.

Income Tax planning demands continual effort in order to be effective. Usually, transactions must be structured correctly before they occur in order to allow proper tax treatment when they are later reported. Waiting until year end to analyze the Income Tax implications of a transaction could be costly.

What about tax return preparation?

Each type of tax requires the filing of a tax return. As a result, the more complex that a person’s asset structure is, the more complex her tax reporting will need to be.

Each type of tax return has the potential of affecting the others. For example, a decedent’s Estate Tax return may have a direct impact on her estate’s Income Tax return and vice versa. It is imperative to have uniform skilled tax counsel for tax return preparation. When tax reporting is done correctly, it has the potential of preserving significant savings for persons of moderate to high net worth.