Editor’s note: This is the first in a series of articles designed to help you demystify the estate-planning process for your clients.

You’ve no doubt observed that your clients may take one of several approaches to estate planning, most of which leave them wishing they had sought professional advice earlier.

The first can best be described as “avoidance behavior,” in which they consciously or by default do nothing in planning for the inevitable, leaving their family to resolve matters during an already emotional and difficult time.

Another approach, only slightly more proactive, is doing it themselves or using online forms that may lead to mistakes or omissions that cannot be corrected once they become incapacitated or have died. This can lead to unnecessary legal fees, taxes and/or litigation, unfortunately defeating their original intentions.

Finally, failing to periodically update their existing estate-planning documents can create unnecessary complications. Federal and state tax laws change on a regular basis, and certain other life events (for example, moving to another state, getting married or divorced, having children) can make changes in their estate-planning documents imperative.

Most estate-planning attorneys spend a considerable amount of time creating and updating their form documents, which are then customized for each client based on the client’s specific needs and situation in life. This helps assure both you and your clients that their estate-planning wishes are current and valid.

The primary goal of estate planning is to ensure that assets are distributed in accordance with the client’s intentions. However, as we know, the tax laws can sometimes get in the way of realizing these intentions. The federal estate tax rate is currently 40 percent, and the estate tax is generally due nine months after death. However, there are significant opportunities to reduce or even eliminate this tax by way of exemptions, exclusions and deductions readily available under the Internal Revenue Code. 

In this article, we’ll discuss several of these opportunities, continuing with others in the second article.

Federal Gift And Estate Tax Exemption

For 2016, the federal gift and estate tax exemption is $5.45 million. This exemption is adjusted for inflation on an annual basis. Above this exemption, the federal gift and estate tax rate is a flat 40 percent.

For a married couple, the total amount of assets equal to twice the exemption amount can ultimately pass to their children or other beneficiaries without incurring any gift or federal estate tax. Under properly drafted estate-planning documents, this tax exemption can be preserved at the first spouse’s death while maintaining all of the assets for the benefit of the surviving spouse. 

One strategy to accomplish this goal is at the first spouse’s death, with assets up to the amount of his or her exemption placed in a family trust for the benefit of the surviving spouse. Although the surviving spouse will be able to receive income and principal from the family trust, the surviving spouse does not own the assets in the family trust for federal estate-tax purposes. Consequently, the assets in the family trust will not be included in the surviving spouse’s taxable estate, which allows those assets and their appreciation in value to pass free of estate tax to the couple’s children or other beneficiaries.

It is important to note that joint tenancy or survivorship assets are generally not available to fund a family trust as they automatically pass directly to the surviving spouse, by operation of state law.

Alternatively, the first spouse could leave all of his or her property directly to the surviving spouse, and an election can be made, under certain circumstances, that will permit the surviving spouse to utilize the deceased spouse’s exemption in addition to his or her own exemption at death. This “portability” feature helps preserve the deceased spouse’s exemption.

Determining which strategy works best for a married couple requires careful consideration of a number of factors, including the spouses’ relative ages, the size and composition of their estates and their desire to provide for grandchildren or more distant generations.

Unlimited Marital Deduction

Individuals may leave all of their property to their spouse without incurring any federal estate tax. This is commonly referred to as the “unlimited marital deduction,” although there are certain pitfalls to avoid.

Leaving all property to a spouse effectively defers the estate tax until the surviving spouse’s death. In the event the surviving spouse’s taxable estate then exceeds the surviving spouse’s estate-tax exemption, including any of the prior deceased spouse’s exemption if portability was elected, an estate tax will be due at the surviving spouse’s death.

However, it is a good idea to avoid any unnecessary buildup of asset value in a surviving spouse’s taxable estate by an overuse of the marital deduction upon the first spouse’s death. If potential estate taxation is an issue because of the size of the respective estates of each spouse, planning should emphasize the full utilization of each spouse’s estate-tax exemption as well as other strategies to reduce the taxable estates of both spouses.

In general, bequests qualifying for the marital deduction include outright bequests as well as bequests to a marital qualified terminable interest property (QTIP) trust for the exclusive lifetime benefit of the surviving spouse. A marital QTIP trust has the added benefit of ensuring that the assets will pass to the intended beneficiaries after the death of the surviving spouse and protecting the trust assets from the surviving spouse’s creditors or a second spouse in the event of remarriage.

Further, if the surviving spouse is not a citizen of the United States, a special marital trust, a qualified domestic trust (QDOT) for the exclusive benefit of the surviving spouse must be used to defer the taxation of the marital trust. The QDOT must comply with specific rules and regulations and be carefully drafted in order to meet these requirements for tax deferral until the death of the surviving spouse.

Annual Tax-Free Gifts

For 2016, the annual gift-tax exclusion is $14,000 and is annually adjusted for inflation. This exclusion enables clients to give up to $14,000 to anyone they choose, and as many people as they choose, each year, free of any gift tax or estate tax. In addition, if they are married, this exemption amount will be doubled to $28,000. So, for example, if the clients are married and make joint gifts to their four children of $28,000 each for a period of 10 years, the couple will effectively reduce their estates by a combined $1,120,000 and no gift or estate taxes will be paid on such sum.

These annual exclusion gifts can be made directly or they can be made to a Section 529 College Savings Account or Custodial Account under the Uniform Transfers to Minors Act or in trust for the benefit of their children or more remote decedents. However, if a trust is used, the Internal Revenue Code requires special provisions in the trust in order to qualify any gifts made to the trust for the annual gift-tax exclusion. For example, a limited power of withdrawal over a gift made to the trust, lapsing within a 30-day time period, can be used to qualify the gift for the annual gift-tax exclusion.

In addition to the annual gift-tax exclusion, there are unlimited gift-tax exclusions for school tuition paid directly to an educational institution and for medical expenses paid to the provider of medical care on behalf of another individual.

In the event a spouse is not a citizen of the United States, a gift to that spouse does not qualify for the unlimited marital deduction. However, it will qualify for an augmented annual exclusion gift to noncitizen spouses, which is currently $148,000 per year. In other words, clients can gift up to $148,000 annually to noncitizen spouses without incurring any gift tax as a result of the transfer.

There are also reasons to gift property that exceeds the annual gift-tax exclusion, making use of the federal gift and estate tax exemption previously discussed of $5.45 million, as adjusted for inflation. Although your clients may currently be using the gift and estate tax exemption, early use of this exemption avoids tax on all future appreciation. If the estate consists of highly appreciating assets, the sooner the asset or a portion of the asset is gifted, the more estate tax will be saved on the future increase in the value of that asset by the time of the client’s death.

In the next article, we’ll discuss life insurance, charitable gifts, basis step-up and the federal generation-skipping transfer tax exemption. 

Debra Smietanski is a special counsel and estate planning attorney with Foley & Lardner LLP. She focuses her practice on complex estate-planning techniques for high-net-worth individuals, and is board certified by The Florida Bar in Wills, Trusts and Estates. She can be reached at [email protected].