When planning an estate or administering a will or trust, what taxes may be involved?

1. Estate Taxes. When a person dies, their gross estate is subject to estate taxes. For years a person could transfer $600,000 at death without any taxation.

In 1998 that amount began to increase. In 2004, the amount that can pass tax free is $1,500,000. Unless repealed or modified, the current law increases that amount to $3,500,000 in 2009. The law is repealed, thus an unlimited amount passes tax free, in 2010. But in 2011 the tax threshold drops back to $1,000,000.

Before 9/11 most estate planners anticipated that a compromise would be reached and many believed the likely “permanent” tax free amount would be $3,000,000. As of September 2004, with 9/11 and the budget deficits, no one is even venturing guesses.

Currently a person can have the following amounts in their taxable estate without incurring any tax. For people dying in:

2004 the tax free amount is  $1,500,000
2005                                   $1,500,000
2006                                   $2,000,000
2007                                   $2,000,000
2008                                   $2,000,000
2009                                   $3,500,000
2010                                   Unlimited
2011                                   $1,000,000

Unlimited Marital Deduction. In addition to the amounts set out above, a person may leave an unlimited amount to their spouse and incur on tax. The gift can be outright or it can be in trust provided it meets certain requirements including that any amount left on the death of the survivor is subject to estate taxes at that person’s death.

2. Gift Tax. Since 1976, estate and gift taxes have been the same and it has been referred to as a unified system. That has now changed slightly. First, the maximum amount you can give this year (or any subsequent year under the current tax laws) without incurring any tax is $1,000,000. Even though you can die with $1,500,000 this year and pay no tax, during your life you can only give away $1,000,000 of it tax free under the current laws.

But note that these taxes are still cumulative. If you give away $1,000,000 this year and then die this year, you only have an additional $500,000 that will pass tax free.

In addition to the above, every US citizen can give, tax free, to as many people as they wish $11,000 a year. This amount was traditionally $10,000 but has been indexed for inflation and has now grown by $1,000. For example, a person could actually give $1,011,000 to his son this year (assuming no prior taxable gifts) without incurring any tax.

The $11,000 is per donor and per donee. Further, it can be repeated every year. Thus, a husband and wife can give $22,000 to their son this year tax free and without invading the $1,000,000 and then can give him another $22,000 next year, again tax free and without invading the $1,000,000.

To illustrate how quickly this can grow; a husband and wife with 3 children and 2 grand children can give $132,000 (2 [husband and wife] x 3 [3 children] x 2 [2 grandchildren] x $11,000) a year to their descendants. Thus over a 3 year period they can transfer, tax free, almost $400,000 and still have the $1,000,000 available.

This $11,000 person donor, per donee, per year, amount is sometimes referred to as a present interest exclusion. For a gift to be treated as nontaxable, it must be presently available to the beneficiary. $11,000 in cash handed to a child qualifies. However, if that $11,000 is put into trust and the child is not to receive these funds for 1 year, then it does not qualify.

A common device, and one used extensively in life insurance trusts, is to give the child a right to withdraw the funds for a limited period of time. This right, frequently referred to a Crummy right of withdrawal, makes the gift a present interest and qualifies as a present interest gift.

3. Generation Skipping Tax. Generation skipping occurs if a person leaves their property in a form that avoids that property being subject to estate taxation on the death of a beneficiary. For example, if I leave my estate to a trust that will continue until the death of my child, the trust would not be subject to the estate tax on my child's death. This is true even if my child is the trustee and the primary beneficiary.

The Exemption. However, there is an exemption amount. As of 2004, the exemption is now tied to the estate tax exclusion amount. So for 2004 the amount that can pass into a GST arrangement without a GST tax is $1,500,000. This amount will rise through 2010 as described above and then fall back to $1,000,000 in 2011.

4. Inheritance Tax (State of Texas). The State of Texas has a death tax; however, it is a sponge or pick up tax and has little impact on planning or administration. However, it may change in the near future. Traditionally this tax required no consideration because it was equal to a federal credit for state death taxes paid. Thus it was merely money that would have otherwise been paid to IRS.

That federal estate tax credit is now being phased out and represents a loss of about $300,000,000 to the State of Texas each year. There are no current plans to change this tax to avoid these lost revenues, but if the Texas budget continues to be tight, politicians may turn to this tax.

5. Income Tax. The income tax has a widespread effect on planning and administration. The following are just a few of the basic issues.

Basic Rule. All income is subject to tax all the time. While a person is living, that person reports his income and pays tax on it. When a person dies, his estate reports all of the income from the date of death until the estate is closed. If there are distributions to beneficiaries, they will report the income and pay tax. If there are no distributions to beneficiaries, then the trust or estate will pay the tax. Except to the extent a distribution is deemed a distribution of income, property distributed to the beneficiary is not counted as income. But, when the property is distributed, the beneficiary begins paying income tax on the income the property generates from the date it is turned over to the beneficiary.

Life Insurance. The proceeds from a life insurance policy are not subject to income tax. However, this should not be confused with the estate tax. Life insurance, unless properly handled, is subject to the estate and gift tax and may be a part of the decedent's gross estate.

Capital Gains: Basis. When you sell an asset, you pay tax on the difference between your basis and the net sales price. Basis is generally the purchase price less any prior claimed depreciation. When an asset is given to you, you take your donor's basis. On the other hand, if you inherit an asset, you get a step up in basis to date of death value. For example: Dad gives Exxon stock to his son; it is worth $8,000 on the date of gift but dad only paid $2,000 several years ago. Son sells the stock for $8,000. The gain (and reportable income) is $6,000. On the other hand if Dad leaves his Exxon stock to his son and on the date of dad's death the stock is worth $8,000. If son subsequently sells it for $8,000, son has a gain of 0 and a tax of 0 .

Capital Gains: Community Property. This step up in basis at death applies not only to the decedent’s property but also the surviving spouse’s community ½ as well. So, if a man dies owning with his wife as community property the Exxon stock referred to above. If wife is left the stock and then sells it her basis is $8,000 not $5,000) ($4,000 plus $1,000).

Deferred Compensation. There is no step up in basis for deferred compensation. If dad has an IRA worth $100,000 and he names his daughter as the beneficiary, the IRA is not only subject to the estate tax but also the income tax. The IRA is a part of the gross estate. Also, income tax must be paid on the IRA.

A spouse can roll an IRA over and treat it as if it was originally hers. A beneficiary can elect to draw an IRA over his or her life expectancy. You should avoid naming an estate as the beneficiary of an IRA, that will probably result in the IRA being fully taxed almost immediately. Finally, a trust should be named as the beneficiary only with the greatest of caution and professional input.