The Death Tax: A primer on Federal and State Estate and Gift Taxes.

First, let me say that the Death Tax no longer affects the vast majority of Americans.  You probably do not have to worry about this.  I wish you did, because that would mean you were doing pretty well in life.  First world problems!

State Death Taxes.  Currently, Arkansas and Mississippi do not have any form of death taxes.  There is a trend among states to get rid of these taxes.  Tennessee has followed this trend.  For 2014, Tennessee levies a tax on estates of deceased individuals to the extent that they exceed $2 million (except where a spouse or charity inherits).  This amount is known as an “exemption.”  In 2015, the Tennessee Inheritance Tax Exemption will be $5 million.  The Tennessee Inheritance Tax will be completely phased out for the year 2016.  The Tennessee tax rate is roughly 9% on amounts that exceed the exemption.

State Gift Tax.  Neither Mississippi nor Arkansas has a gift tax.  Tennessee has followed suit having repealed its gift tax effective for 2012.

Federal Estate and Gift Taxes.  Please note that the Federal Estate and Gift taxes are highly interrelated.   The amount that can be passed at death takes into consideration amounts that you have gifted during your life.  Gifts during life reduce the amount that can be passed at death.  In other words, you can use your exemption during life or you can use it at death, but you can’t use it twice!

Federal Estate Tax.  The Federal Estate Tax is a tax on all assets that you own (including life insurance) at the time of your death.  The current amount (2014) that can be passed to anybody without incurring tax is $5.34 million.  This amount is indexed for inflation, and has already increased from $5 million in 2011 to its current levels. The current rate is a flat 40%.

It is worth noting that the exemption was $600,000 in the late 90s and early 2000s with a rate that topped out at 55%.   We have come a long way.

Just like with the Tennessee Inheritance tax, any amount can be passed tax free to spouses or to a charity.

If you’re married, with tax planning, you can double your exemption amount to $10.68 million.

An Estate Tax return is due on certain estates within 9 months of death where the estate of the deceased individual exceeds the amount that can pass tax free (even if there is not any tax because everything passed to the surviving spouse or to charity).

Note: Even where the estate is less than the exemption, it may still be prudent to file a tax return.  For instance, if there are any hard to value assets in the estate that could increase the value of the estate  such as a family business.  Filing the return starts a three year statute of limitations against the Treasury.

Likewise, a timely tax return is required in order to pass the deceased spouse’s exemption to the surviving spouse.  This is known as “Portability.”

Federal Gift Tax.  Essentially, a tax is due on amounts gifted to individuals (other than a spouse or to charity) that exceed in the aggregate your Federal Estate and Gift Tax Exemption.  As discussed above, this is $5.34 million for 2014.  Gifts to individuals that exceed $14,000 per gift maker per gift recipient each year must be reported to the IRS.

Annual Exclusion Gifts.  The $14,000 referenced above is the amount that a person can give another annually without having to report the transaction and without using their lifetime exemption.  These gifts are totally off the record and are perhaps the most widely known and utilized way to avoid these taxes.

To illustrate: Grandmom has two children and and six grandchildren.  Grandmom can make eight gifts of $14,000 or a total of $112,000.  Grandmom is not limited to eight gifts.  She can make gifts to spouses, friends or anybody without having to report these gifts or incurring any taxes.  As you can see, this is a very useful tool.

Spouses can each make the $14,000 gifts.

Income Tax Consequences.  The income tax consequences of receiving a gift or bequest is worth mentioning.  Generally, the receipt of a gift or a bequest is NOT income.  There are a few exceptions to this including the inheritance of a retirement account, annuity, savings bond or certificate of deposit.

All of these exceptions involve income that has never been taxed.  For the retirement accounts and certain annuities (known as qualified annuities), the deceased took an income tax deduction when he or she put the funds into the account.  For other annuities (non-qualified), certificates of deposit and savings bonds, the amount of tax is the value of the asset that exceeds what the deceased put into it; i.e., the gain.

Basis – Generally.  One other income tax aspect that I should mention is basis.  First, basis is an income tax concept that is used to calculate the amount of gain when an asset is disposed of.  Normally, this is the amount that was paid for something; cost basis.

Basis – Gifts. For a gift, its called transferred basis.  The actual rule depends on if the gift is sold by the recipient for a gain or for a loss.

Sold for a gain.  If an asset is sold in the hands of the recipient for an amount that exceeds what it was purchased for originally, the amount of the gain is the sales price less the cost basis (what it cost the gift donor).

Sold for a loss.  The rules seek to limit the amount of the loss.  If an asset is sold for a loss, the amount of the loss is calculated by subtracting the lesser of (1) the fair market value of the gift at the time it was made and (2) the asset’s cost basis (what the gift donor paid for it originally) from (3) the sales price.

Basis – Inheritance.  The basis in an inherited asset is known as “stepped-up” basis.  Basically, the basis is stepped up from the asset’s cost basis (what the deceased paid for it) to the asset’s fair market value at the date of death of the former owner.  This is a significant tax advantage for assets that were purchased long ago and have significantly increased in value from when they were purchased.

More to come.  Stay tuned.

Rob

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