Estate Taxes

With the significant increase in the federal estate tax exemption in recent years, the focus for many clients has turned from estate tax planning to income tax planning.

Fifteen years ago the estate tax exclusion amount was $675,000. Today the federal exemption is $5.43 million and in 2016 will be $5.45 million. The Illinois estate tax exemption, however, is stuck at $4 million, which is still sufficiently high to allow most decedent’s estates to avoid filing an estate tax return and paying the estate tax.

At the federal level, a concept called portability applies. When the first spouse dies, that spouse’s unused estate tax exemption can be transferred (ported) to the surviving spouse. This means that, at least in theory, a married couple could have a combined estate of $10.86 million and experience no federal estate tax. Interestingly, only 0.14% (that is, fourteen in ten thousand) households are expected to have estates larger than the two-spouse combined federal estate tax exemption.

Illinois, however, has not adopted portability. Therefore, a couple with a potential estate approaching $4 million should engage in estate planning to avoid or minimize the potential estate tax.

For the vast majority of individuals and couples whose estates are considerably less than $4 million, generally no estate tax planning is warranted. Rather, the focus is on income tax planning and, more specifically, tax basis adjustment.

A person’s tax basis in an asset is generally the cost of the asset or the value of the asset if received as a result of someone’s death (or the giver’s tax basis if received as a gift during the giver’s life) less allowable depreciation deductions. When an asset is sold, taxable gain or loss is usually measured as the difference between the net sales price and the seller’s adjusted tax basis. Generally, when a person dies the assets in his or her estate receive a step-up in income tax bases equal to the values of those assets as of the date of death. (Some notable exceptions exist, however, such as assets funded with pre-tax contributions.)

Under fairly traditional estate tax planning for married couples, on the death of the first spouse assets with a value equal to not more than the decedent’s estate tax exemption were sheltered by channeling them to a by-pass trust, typically called a Family Trust, for the benefit of the surviving spouse. The Family Trust would be structured so that, when the second spouse would die, the value of the assets in that trust would not be subject to estate tax in the surviving spouse’s estate.

The protection from estate tax, however, meant that the assets in the Family Trust did not receive a step-up in tax bases. As a result, any significant appreciation in the value of the assets since the death of the first spouse could lead to substantial income tax when the asset was sold.

Therefore, if estate tax is no longer a concern, using a Family Trust might no longer be good planning. Instead, other estate planning techniques are available to safeguard the assets of the first spouse to die, allowing the surviving spouse to have the benefit of those assets during the balance of his or her life, but ensuring that those assets receive a step-up in income tax bases upon the death of the second spouse.

We are happy to advise clients regarding these techniques and to otherwise update their estate plans so that the plans are consistent with applicable law and any changes in family situations.