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Four Things That Make Estate Planning Confusing

1.     Estate, Estate, and Estate

 

What does the word “estate” mean in estate planning? Unfortunately, it means different things in different situations.

 

An estate can mean all of the assets someone owns at death. A person’s heirs may fight over the estate. Basically, an estate is how rich someone is… or was.

 

An estate can also mean the probate estate, the property transferred through a will or otherwise unaccounted for that has to go through the court system to be legally transferred to someone else.

 

Finally, there is estate as in an estate plan. This is the overall plan for dealing with incapacity and wealth transfer for an individual. In addition to wills and trusts, it can include beneficiary designations, powers of attorney, healthcare directives, and other planning tools.

 

2.     Tax, Tax, Tax, & Tax

 

When a person dies, there are four different tax returns that may have to be filed - three income tax returns and a transfer tax return.  

 

There is an income tax return for the final year of the person’s life, an income tax return for the property of the deceased if the property earns income after the death but before it’s transferred to heirs or beneficiaries, and an income tax return if there is a trust that also owns the property that earns income after death.

 

Then there may be a transfer tax return. This is the estate and gift tax, which is a tax on the lifetime and at death transfer of assets. If your net worth isn’t in the millions you won’t need to file this.

a quartet of tax returns income tax return individual normal tax return last year life ss#, estate of income before distributed, tax id#, trust income from trust property tax id#, estate and gift tax return indviddual wealth as of date of death not income

3.     Getting a Gift / Giving a Gift

 

If someone receives a gift, they don’t have to pay any taxes or report it to the IRS. The gift giver may have to report the gift to the IRS in the year the gift was made and could end up paying a transfer tax later.

 

The estate and gift tax is a tax on transfers of property. The “estate” part is the value of transfers at death. The “gift” part is transfers during life. It wouldn’t make sense if someone could transfer millions or billions right before they die and avoid the tax. Hence, it’s the estate AND gift tax.

 

Each year gift-givers are supposed to file a gift tax return if they give out gifts over a specified amount per gift receiver ($18,000 for 2024). When the gift giver dies, all of the yearly reported gifts, plus the estate value, determine the estate and gift tax due.

 

It’s not a totally free ride if you receive a gift. It’s necessary to know how much the person that gifted, say stock, bought it for themselves. If it was bought for $10,000, and it’s later sold by the gift receiver for anything above $10,000, there is likely a taxable gain for the receiver in the year it is sold. So if it’s sold for $15,000, there’s a $5,000 gain.

 

In short, the tax on the transfer might be paid by the gift giver at death.  The tax on the increase in value of the transferred property is eventually paid by the receiver when they sell the property.

Gfits give up to $18k per person per year, you get $18,000, you get $18,000, you get $18,000, you get $18,000, you get $18,000

 

4.     What is a Trust?

 

When most people talk about a trust, they usually talk about it in relation to “avoiding probate”. But what is a trust, and how does it do this?

 

A trust is a set of relationships between three classes of people – 1) a settlor who sets up the trust and transfers the property to 2) a trustee, who manages the property, for the benefit of 3) the beneficiaries, who receive the money generated by the property in the trust or the property itself.

 

When someone creates a ‘revocable trust’, they are usually all three of these people – settlor, trustee, and beneficiary. They have complete power over the trust and its property. It’s like they still own the property. It hasn’t been given to someone else. They can revoke the trust if they want and take back the property.

 

At death, a new trustee takes over and new beneficiaries come into existence. The trust is now irrevocable. The trustee must follow the instructions in the trust. It’s very similar to a will at this point.

 

Because the trustee is the legal owner, they can transfer property. This is how a trust avoids probate. It’s not property owned by the recently deceased. The new trustee has the legal authority to transfer the trust assets to the beneficiaries. They don’t need to get court legal authority and can ‘avoid probate’.

a simple trust diagram settlor creates trust by contributing property  trustee manages trust beneficiary gets income

 

Bonus!

 

5.     Add in Marriage and Community Property

 

All of the above applies to a single person. But what if the deceased was married? The same issues apply but with additional complications due to community property ownership for married couples and special rights and rules for the surviving spouse.

This more than doubles the complexity. This is in part because it creates many more planning opportunities (some would call them schemes) to delay potential taxes.

 

Bonus! Bonus!

 

6.     The Rules Change All the Time

 

If you’re playing a game and the rules change, you have to change your strategy. Congress changes tax laws all the time. What’s true today might not be true next year and probably not five years from now.

 

estate tax at year of death 2005 estate value greater than $2 million tax rate 47%, year 2011 estate value greater than $5 million tax rate 40%, year 2024 estate value greater than $13.61 million tax rate 40% in 2026 will be estate value greater than $7 million ish tax rate 40% unless law changes, double if married

Final word

 

Why is this all so complicated? There are many interested parties and significant amounts of money and property changing hands. That’s not a recipe for simplicity.

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