Estate (Death) Taxes 101 Crash Course - As of October 2022

"How long have you had these droids?" "There aren't the droids you're looking for." - Old Ben, evading a Galactic Empire (IRS?) checkpoint. Star Wars, Episode IV, A New Hope.

Special Disclaimer for IRS Blog Posts

1. This blog post intended for general discussion and to illustrate general rules.

2. IRS rules and regulation are NOTORIOUS for the exceptions to the general rules having their own set of exceptions! Please consult your attorney or CPA for advice specific to your situation!

Does TEXAS have an Estate / Death Tax?

Texas does not have a state level income tax and it used to have an inheritance tax but it is no longer in effect.

Texas DOES have a sort of income tax for businesses (the Texas Franchise tax) but many small businesses do not pay the Texas Franchise tax because the no tax due threshold is a touch over $1.1 million in annual revenue.

How Does the Federal Estate (Death) Tax Work?

We often describe the estate (death) tax by comparing it against the separate income tax system. Please see comparison below.

Federal INCOME Tax System

1. Annual tax, typically on a calendar year basis

2. Income tax is due every year on April 15 (before extensions).

3. Taxable amount is based on taxable income (e.g., wages) minus deductions (e.g., standard or itemized).

4. Tax rate is based on tax brackets - as you have more income you move into higher tax brackets (e.g., 10, 12, 22, 24, 32, 35, 37 percent brackets)

5. Highest tax rate is 37% once taxable income exceeds ~539,000 for a married couple (for tax year 2022)

6. Reported on IRS Form 1040

Federal ESTATE Tax System:

1. One-time tax assessed when you die.

2. Estate tax is due nine (9) months after you die (before extensions)

3. Taxable amount is based on your net worth (assets minus liabilities) minus your estate tax exemption

4. Tax rate is essentially 40% flat tax on assets exceeding your estate tax exemption

5. Default estate tax exemption in 2022 is ~$11 million (rounded) and scheduled to sunset to ~$5 million (before inflation adjustment) on January 1, 2026

6. Reported on IRS Form 706

7. Because you are deceased in an estate tax case, the tax is paid by your Executor from your estate funds prior to making distributions under your Will / Trust.

Estate Tax Example: Rick and Ilsa

Facts for example case:

1. Rick and Ilsa, married.

2. Have three kids together. No kids from prior marriages.

3. Net worth of $15 million. No debt.

4. To simplify the example, assume their net worth does NOT go up or down over time.

5. They are a Texas couple and all of their property is community property.

6. Their wills are mirror images - 100% to my spouse, otherwise to my kids equally.

7. They each have an estate tax exemption of $11 million (rounded to simplify math).
   

Assume Rick Dies First and Everything Goes to Ilsa. Does Rick's Estate Owe Estate (Death) Taxes?

Rick's estate will NOT owe federal estate (death) taxes in this case. We like to think of the estate tax as an "over or under" rule - as long as Rick's net worth is under his estate tax exemption level when he dies he is free of the estate tax!

Reasons Rick's estate does not owe estate taxes:

1. Rick's share of the community property is $7.5 million. Although Rick and Ilsa's total net worth is $15 million, IRS respects the underlying Texas community property rules so Rick's net worth is $7.5 million for estate tax purposes.

2. Rick's $7.5 million net worth is LESS THAN his $11 million estate tax exemption. Because Rick's net worth is FULLY COVERED by his estate tax exemption, he does NOT owe estate taxes at death.

3. Furthermore, even if Rick had been worth $100 million when he died, he is allowed to transfer an unlimited amount of wealth to his spouse without that wealth being subject to estate (death) taxes or using up his estate tax exemption.
   

How Does Our Counterparty, the IRS, Feel About This Result?

To the extent IRS has feelings, we suspect the revenue-collection arm of IRS is quite happy with this result.

Why? Because now all the wealth is concentrated in Ilsa's name and will be subject to estate taxes when Ilsa dies. The IRS is an undying institution with a presumably unlimited time horizon so it would he happy to wait to charge 40% on a large growing balance in Ilsa's name.

The IRS points out that in a more realistic example, Rick and Ilsa's assets will likely grow in value over time leading to an even bigger estate tax bill coming due on Ilsa's passing.

Assume Ilsa Has Inherited Everything from Rick. Does Ilsa Owe Estate Taxes on Her Death?

Under these facts, yes. We discuss estate tax prevention strategies further below.

A summary of Ilsa's situation:

1. Ilsa's net worth is now $15 million (she inherited Rick's $7.5 million and kept her own $7.5 million)

2. For simplicity we assumed no growth in asset values between Rick's passing and Ilsa's passing.

3. Ilsa dies unmarried.

4. Ilsa's estate tax exemption is $11 million (rounded to keep math simple).

In this case, Elsa's estate owes $1.6 million to IRS. Here's how that happened:

1. Ilsa's net worth at death is $15 million.

2. Ilsa's estate tax exemption at death is $11 million.

3. Result = Ilsa has $4 million of assets subject to estate taxes ($15 million minus $11 million)

4. The estate tax rate is 40% on each dollar over the estate tax exemption

5. Estate tax due = $4 million x 40% = $1.6 million.

Note: Ilsa died unmarried so unlike Rick she does NOT have access to a marital deduction in her estate tax calculation.

Dear reader, we don't know about you but the idea of writing a $1.6 million (that's more commas and zeroes than we care to entertain) check to IRS is not what we consider a fun experience and we hope to avoid that situation for you!

Below, we discuss some (but nowhere near all) strategies for avoiding estate taxes.

What Could Rick and Ilsa Have Done to Avoid Owing Estate Taxes?

If you Google for estate tax prevention strategies you will find an alphabet soup of strategies with fanciful names! We admire the creativity of some tax planners!

For this blog post we stick to tried and tested strategies that have survived IRS scrutiny in the past and that we believe may be a good fit for this case. Our approach is to illustrate the least invasive and least complicated solutions that zero out the estate tax bill for Rick and Ilsa.

1. Annual lifetime gifting. As of 2022 the annual gift tax exclusion is $16,000 per year, per person. That means Rick can give $16,000 per year to an individual without triggering gift taxes (or using up his estate tax exemption). Same for Ilsa. Recall that Rick and Ilsa have 3 children. What if each of those 3 children are adults and each have 2 children of their own? That 3 + 2 + 2 + 2 = 9 annual gifting beneficiaries! 9 beneficiaries x 16,000 annual gift x 2 (gift from both Rick and Elsa) = 288,000! That's $288,000 that can be transferred to family members each year without triggering gift taxes or eating up Rick and Ilsa's estate tax exemption. Potential downsides = Rick and Ilsa might be asset rich but cash poor (e.g., real estate or small business investors). Also, for many families the amount of the annual gifts may not be enough to move the needle compared to the growth in value of appreciating assets such as a small business.
   

2. Portability (DSUE) Estate Tax Return. The general rule is that when Rick dies his estate tax exemption dies with him. HOWEVER, starting on January 1, 2011 we gained the ability to file an estate tax return (often called a "portability return") that transfers Rick's unused estate tax exemption from his estate over to Ilsa! Recall - when Rick died his estate tax exemption was $11 million. Rick's will called for all of his assets to pass to his spouse. The gift of Rick's assets to Ilsa at death did NOT use up any of Rick's estate tax exemption because of the unlimited marital deduction rule for estate taxes. Result = when Rick died his $11 million estate tax exemption (shield) was left completely unused. Since Rick died after January 1, 2011, we have the ability to file an estate tax return that TRANSFERS Rick's $11 million estate tax exemption from Rick to Ilsa! Unfortunately, IRS does NOT let us transfer Rick's estate tax exemption unless we file the estate tax return (IRS Form 706). Fortunately, in Rick's case, we will not owe estate taxes to IRS on the estate tax return. Result 1 = Ilsa's combined estate tax exemption is now $22 million because she has both her own personal $11 million estate tax exemption and she received Rick's $11 million estate tax exemption because we filed the "portability" estate tax return to transfer Rick's exemption to Ilsa. Result 2 = With a new $22 million estate tax exemption (estate tax shield), Ilsa would NOT owe estate taxes at her death because her $15 million net worth is FULLY COVERED by her combined $22 million estate tax exemption (combination of her $11 million exemption and the $11 million exemption received from Rick via his estate tax return) . Victory!

DOWNSIDES TO PORTABILITY? The downside of a portability estate tax return is that it takes time and money to file because it is basically a date of death balance sheet of all of Rick's assets. In your author's opinion a high quality estate tax return with sufficient exhibits and a good summary cover letter designed to survive an IRS audit can easily take 10 hours of work or more. In our opinion the best estate tax return is so well documented and painfully easy to understand that the IRS agent doing the initial review views it like a prickly porcupine that should be sent on its way with a rubber stamp of approval never to be reviewed by IRS again. IRS allows simplified reporting for estate tax returns filed solely to transfer an estate tax exemption from one spouse to another (e.g., Rick and Ilsa's case) and lets you round values to the closest $250,000. In your author's opinion this simplified reporting is an audit TRAP. Your author acknowledges that he may sound paranoid but posits that he would rather be paranoid on your behalf than wrong and sitting on the wrong side of an IRS audit (Spanish inquisition?) with a thin defense file! Reasoning: As of October 2022 we saw IRS job postings on USAJOBS.gov paying $150,000/yr for new IRS estate tax examination employees since IRS just got $80 billion of new funding under the 2022 Inflation Reduction Act. Your author confesses that he briefly considered switching over to the dark side with that kind of starting pay! The industry papers we've read indicate that IRS is under pressure to increase the percentage of returns it audits and we think estate tax returns will be an easy target since IRS has a full balance sheet of your assets and a lifetime of income tax returns at your death. When we spoke to an established estate tax litigation firm in California (lots of business due to the technology industry) they told us the number one issue litigated on estate tax returns is valuation (e.g., you reported the house at $1 million but IRS really thinks the fair market value is $3 million). Common valuation issues: value of investment real estate, closely held businesses and reported discounts. If you get a portability return done we strongly urge you to get formal appraisals (we acknowledge they are expensive and time consuming) done so you have a leg to stand on if (heaven forbid) you get an IRS audit letter from a newly hired IRS field agent looking to make their first catch of the day. *Steps off soapbox.* Apologies for the rant. Your author feels strongly about preventing his clients from owing estate taxes and avoiding IRS audits.

What Are Some Items We Could Not Cover Due to Time?

Thank you for reading this far! Here are some items we could not cover due to time but hope to cover in future blog posts!

1. Bypass (Credit Shelter) Trust - good for sheltering assets that will grow in value but lose the benefit of a stepped up income tax basis when Ilsa dies

2. Spousal Lifetime Access Trusts (SLATs) - the big guns of estate tax prevention. However, cause serious issues in event of a divorce.

3. Family Limited Partnerships with valuation discounts for lack of marketability, control. A time-tested technique from back when the estate tax exemption was only $600,000.

4. Life insurance trusts. Also a time-tested favorite. Use to keep life insurance death benefits from being subjected to the 40% estate tax.

5. INCOME tax issues - namely stepped up income tax basis issues.
   

What To Expect Next?

We hope this has been helpful! Please feel free to call or email us if you are looking for some personalized estate tax prevention work!

P.S. We want to acknowledge that while we poke fun at IRS, we happen to know many IRS agents are honest and hard working public servants just trying to carry out the law as it is written. The real villain is Congress because they're the ones who pass the laws! And with that, your author gives up any hope of running for elected office!