Many estates can save money by filing tax returns – even if they don’t have to

And people with older wills should have them reviewed now, due to a new law from Congress

A federal estate tax return doesn’t have to be filed every time someone dies. In fact, most estates never have to file one. In 2011 and 2012, a return has to be filed only if the person’s estate (including property, life insurance, taxable gifts, etc.) is worth $5 million or more.

However, even if a return isn’t required, a recent change in the law means there could be big tax savings for many families if they file one anyway.

The change applies to estates of people who die in 2011 or 2012 and are survived by a spouse.

There are strict time limits for filing a return, so if you know of someone whose family could take advantage of these savings, you or they should speak with an attorney right away.

Also, if you have an older will that includes a trust designed to reduce taxes when a surviving spouse later dies, you should have the will reviewed, because under the new law there might now be better alternatives.

How it works

Generally, when a person dies, his or her estate can give an unlimited amount to a surviving spouse. After that, if the person’s bequests (plus large lifetime gifts) total more than a certain “exemption amount,” then an estate tax is due. For 2011 and 2012, the exemption amount is $5 million.

Traditionally, the exemption amount applied separately to each spouse. So if a husband died first, his estate could use the exemption amount, and when his wife died later, she would get her own exemption amount.

But under a change in the law starting in 2011, if the first spouse to die doesn’t use all of his or her exemption amount, the difference can be passed along to the other spouse. So suppose a husband dies and doesn’t use any of his $5 million amount (because he leaves everything to his wife). When the wife dies, her exemption amount will be her own $5 million plus the $5 million that the husband didn’t use. So instead of being able to leave $5 million tax-free to her heirs, she can leave $10 million tax-free – a potential savings of millions of dollars.

However, this only works if the husband’s estate filed an estate tax return and elected to pass the exemption amount on to his wife. If the husband’s estate didn’t file a return (because it wasn’t legally required), then all the potential tax savings are lost.

This means that it’s almost always a good idea to file an estate tax return for anyone who dies in 2011 or 2012, if they are survived by a spouse.

Even if it seems highly unlikely that a surviving spouse will be worth more than $5 million when he or she dies, it’s still a good idea to file a return, because the $5 million exemption amount only lasts through 2012. After that, Congress can change it, and we don’t know what amount Congress will choose. It appears that if Congress doesn’t do anything, the amount will be reduced to just $1 million in 2013.

Because the current law only lasts through 2012, there are a lot of questions and uncertainties about what will happen after that. It’s possible that the law will change again, and the tax savings may be reduced or lost by the time the surviving spouse dies. However, in most cases, the cost of filing an “unnecessary” tax return will be small compared to the potentially huge savings down the road.

(In a few cases, executors might be put in an awkward position because the heirs who would have to pay for filing the return might be different from those who would benefit from the increased exemption. In such a case, the executor might want to ask the surviving spouse to pay the cost of the filing, since he or she will benefit from it.)

Many wills need to be reviewed

In the past, many people tried to achieve a similar result – using both spouses’ exemptions – through the use of a trust, sometimes called a “bypass trust.” Typically, when the first spouse died, some of his or her assets (often a sum equal to the current exemption amount) went into a trust, and the rest was left directly to the surviving spouse. The trust might pay income and principal to support the spouse during his or her lifetime, after which the assets would go to children or other heirs. When the surviving spouse died, the trust property wasn’t included in his or her estate, and so it didn’t “count” toward the exemption amount.

The new law might make these kinds of bypass trusts unnecessary for some people – at least until the end of 2012.

You might want to consider the costs and benefits of eliminating such a trust from your will, or at least providing that the trust provisions won’t take effect unless the law changes again such that the trust becomes a good idea.

Some of the disadvantages of a bypass trust include:

  • The surviving spouse has less flexibility and access to the assets.
  • There are expenses in managing the trust, filing trust tax returns, and sometimes hiring an outside trustee.
  • If trust property is sold after the surviving spouse dies, the “basis” for capital gains tax purposes is its value at the time of the first spouse’s death – whereas without a trust, the basis would be the (presumably higher) value at the time of the second spouse’s death.

On the other hand, there are some powerful reasons to keep a bypass trust. For instance:

  • Assets in such a trust will be protected from a surviving spouse’s creditors, and from the actions of a future spouse if the surviving spouse remarries.
  • A spouse might want to put property in a trust to make sure that when the surviving spouse dies, the assets will go to the person’s children from a prior marriage.
  • A bypass trust can also reduce state estate taxes, as well as generation-skipping transfer taxes.
  • A bypass trust shields all future appreciation from estate taxes – even if the assets in the trust grow in value far beyond the amount of the first spouse’s exemption.

As an aside, if your old will says that the amount that will go into a bypass trust is equal to the exemption amount, you might want to review this in light of the fact that the exemption amount in 2011 and 2012 has been dramatically increased to $5 million. You might prefer to say that the trust assets will be the exemption amount or a certain dollar figure, whichever is less.

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