For today's business owner, death can mark the beginning of a significant tax problem. The investment and sweat that went into building their business year after year could add up to a whopping federal estate tax bill for your heirs-up to 50% of the combined value of their company and other assets.
With careful planning, however, there are still ways to reduce the tax burden on your loved ones while keeping the business intact. Here is an overview of some available estate planning options.
Marital Deduction. One of the most common estate tax reduction strategies is the so-called "marital deduction." This allows you to leave an unlimited amount of assets to your surviving spouse tax-free for federal estate tax purposes. Marital deduction bequests may be outright or in trust. A trust may be needed if significant assets are involved and professional management and administration are desired.
Also, a trust may afford protection against the demands of relatives and creditors. This deduction must be used carefully, however, as using it to the fullest extent possible may adversely affect the surviving spouse's estate tax situation. Note also, if you and your spouse are not U.S. citizens, special requirements must be satisfied for the marital deduction to apply.
The Estate Tax. With proper use of the marital deduction, no estate taxes need be owed upon the death of the first spouse. But there's a limit on what can be passed tax-free to other heirs, either as gifts during your lifetime or from your estate. In 2002, the gift and/or estate tax credit allows each spouse to exclude up to $1 million in value from a taxable transfer. The gift tax credit stays at $1,000,000 with no scheduled increases.
The 2001 tax law gradually increases the estate tax-free figure, scheduled to be $1.5 million in 2004, topping off at $3.5 million by 2009. This amount, known as the exemption equivalent, may be large enough for you to pass on your entire business free of federal estate taxes. But after both you and your spouse die, estate taxes will be due if the surviving spouse's estate is worth more than the exemption equivalent. Estate taxes start at a hefty 37% on the first dollar above the exemption equivalent and increase to 48% (in 2004) on amounts over $2.5 million. Tax rates are scheduled to drop 1% each year until 2007 when it hits 45%. While estate taxes are scheduled to be eliminated in 2010, the next year the tax rates return to 55% with an exemption of $1 million.
Sizing Up Your Estate. At first blush, the amount that is exempt from estate taxes, currently $1 million, may sound like a huge sum. Many business owners mistakenly assume they have less than that and figure no special tax planning is needed. Unfortunately, they tend to undervalue their assets or fail to take all of them into account. They may have accumulated several hundred thousand dollars of equity in their home. The value of their company, rental properties, pension plan and other savings are also part of your estate, as is your life insurance policy if you own the policy or have incidents of ownership in the policy (such as retaining the power to change the beneficiary) at your death.
Even if they don't consider themselves wealthy, it's easy to see that $1 million-plus in assets is quickly accumulated. If a client and their spouse had combined assets of less than $1 million when the will was first written, but now exceed that amount, it's likely they'll need some estate planning.
Credit-Shelter Trust. Used correctly, a credit-shelter trust can double the amount clients and their spouses leave to your children free of federal estate taxes. Here is an example based on the $1 million exemption amount allowed in 2002. Suppose they leave your entire $2 million estate outright to their spouse. After their death, the estate incurs no federal estate taxes because of the marital deduction. But upon the death of the spouse in 2002, only half the estate ($1 million) is exempt. Their children will pay $435,000 of federal estate taxes on the other half.
That's poor planning. Instead, suppose they willed only $1 million to their spouse outright, and put the other $1 million in a credit-shelter trust. The spouse would be entitled to income from the trust after their death. But after the death of the spouse, the assets in the trust won't be part of the spouse's estate, so they'll also pass tax-free to their children. And the other $1 million is also untaxed due to their spouse's own $1 million exemption. Assuming no appreciation or depreciation of the assets' values, the children inherit $2 million free of estate tax.