The federal estate tax is back in 2011

The federal estate tax is back in effect as of January 1, 2011.

As a result of a last-minute compromise in Congress, the estate tax will be temporarily reduced for two years. In 2011 and 2012, the tax will apply to estates over $5 million, at a rate of 35%. However, unless Congress changes the law again, after 2012 the tax will apply to any estate over $1 million, at a rate of 55%.

As a result, the estate tax is no longer a problem just for the rich. A huge swath of the middle class could now be affected if, at some point in the next few years, the value of their house, their retirement savings and the proceeds of their life insurance tops $1 million.

In addition, many states have their own estate taxes and their own rules, and these can be less generous than the federal rules in some ways.

That makes it critically important to plan your estate – or re-evaluate your estate plan – if you haven’t already done so.

Over the past year or so, some people have shied away from estate planning. The combination of the repeal of the tax in 2010 and the general uncertainty about the future of the tax has led many people to hold off planning until the situation was resolved.

However, with the return of the tax and the possibility of a much more severe tax rate in two years, anyone who might be subject to the tax needs to take steps quickly to protect their loved ones.

Many different estate tax ideas have been proposed in Congress, and a good plan needs to be flexible enough to protect you regardless of how the rules change in 2012 and beyond.

However, failure to plan around the tax is a risk that no one who may be subject to it should be taking.

On the positive side, the current economic environment – with ultra-low interest rates and depressed valuations of real estate and businesses – is a great time to plan transferring assets to the next generation. There might never again in our lifetimes be so many opportunities to transfer wealth at a tax discount.

For instance:

  • If the value of your house has declined, considering putting it into a “qualified personal residence trust” for your children. You can continue living in the house for a specific number of years, after which it will pass to your children (or other trust beneficiaries). The key is that you will have given the house to your children at its current, lower value for estate and gift tax purposes. If the house increases in value in the coming years, that increase in value won’t be subject to taxes. In addition, you can further lower the taxable value of the house by the subtracting the value of your right to live there for a number of years.


  • You can also sell your house to a “grantor trust” in return for a promissory note, and then rent it from the trust for as long as you like. This has many similar tax advantages.


  • If you’re nearing retirement and the value of your family business is temporarily depressed, consider selling it to a family trust in return for an annuity. If it’s done properly, the sale will be considered a fair trade and it won’t trigger gift taxes. You’ll get a steady stream of revenue for life, funded by the business operations. And when you die, no estate taxes will be owed on the value of the business. If the value of the business is temporarily depressed, you’ll have a lot more flexibility now to set lower annuity payments, which will allow more assets to pass to your heirs without taxes.


  • Make a long-term loan to your children. With interest rates at historic lows, you can lend money to children at extremely low interest rates without the IRS considering the loan to be a gift that is subject to taxes. If your children can use the money to invest or to start a business, you’ll have helped them out tax-free.


  • Even better, make a long-term loan to a trust for your children. If you loan money to a grantor trust for their benefit, the interest payments on the loan will not be considered taxable income, and you can pay the income taxes on the trust’s investments, thus shifting more money to your children.


  • If the value of your investments has been reduced, now might be a great time to get some of them out of your estate for tax purposes. One way to do this is to put investment assets into a trust that will pay you an annuity for a term of years, after which the assets will go to the children. This avoids any tax on the appreciation of the assets over the term of years, plus you can get a further tax break based on the value of the annuity. The amount of this tax break depends on an IRS interest rate – the lower the interest rate, the bigger the tax savings. And with interest rates at record lows, this can be a great time to use this technique.

With a renewed estate tax that could soon take a big bite out of inheritances – and force the untimely sale of businesses and real estate to pay Uncle Sam – combined with excellent planning opportunities created by low interest rates and valuations, there has never been a better time to create a smart estate plan to protect your loved ones.

The renewed estate tax, plus many planning options that result from low interest rates and asset valuations, make this a great time to transfer wealth.

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