Question: This one actually came from conversations with my own family, during which several family members raised concerns about having to pay federal estate taxes after the older generation of the family passed away and the farm was left to the younger generation. Realizing how many misconceptions there are about the current status of the federal estate tax, I thought a blog post offering some basic information might be helpful.
Answer: For the vast majority of farm and ranch families (estimated at 98%), the federal estate tax will not apply. But given the high tax rate (40%) imposed if an estate owe the tax, it is critical that farmers and ranchers carefully consider what options may exist to avoid owing this tax.
Additionally, although most states (including TX, NM, and OK) have abolished state inheritance/estate taxes, some have not. Here is a link to determine what the status is in your home state. If you live in one of these states, consult with an attorney to determine how the state laws apply and might impact you. This article will discuss only the federal estate tax issues.
Here are some important items to consider about the federal estate tax.:
- When does the federal estate tax apply? The federal estate tax is essentially a tax on a person’s right to transfer property at death. Under current law, the vast majority of farm and ranch families will not be faced with owing any federal estate taxes. This law, passed initially in 2013, set the exemption at $5 million per person, adjusted annually for inflation. For 2016, each person has a $5.45 million estate tax exemption. For a couple, that means the total exemption is $10.9 million. Therefore, if an estate is worth less than $5.45 million, there will be no estate tax liability. If, however, an estate is worth more than the $5.45 million exemption, the federal estate tax does apply. This is extremely concerning for those landowners, because the tax rate is 40% on any amount over the $5.45 million. Keep in mind that although this law is “permanent,” Congress could always change the exemption amount or tax rate in the future.Importantly, transfers from one spouse to another have an unlimited exemption–meaning the the federal estate tax does not apply. So if a husband dies first and leaves the farm to his wife, no estate taxes would be owed upon his death. Upon the wife’s death, however, if the estate was worth more than the current estate tax exemption, the tax payment would be owed by the heirs.
- How do you calculate the value of an estate? The value of an estate is essentially the current fair market value of the estate’s assets at the time of the owner’s death. This includes assets like real property, cash, investments, and business interests. It also generally includes the value of any life insurance policies if the decedent held “incidents of ownership.” [For more info, click here.] Property held by a revocable living trust will also be considered as part of the person’s estate due to the decedent retaining incidents of ownership. The total fair market value of assets is the “gross estate.” There are certain deductions that may be taken from the gross estate value, including the outstanding balance of mortgages, funeral expenses, estate administration expenses, transfers to qualifying charitable and educational organizations, and certain other debts, to get the net value of the estate, which is what is considered in determining whether estate taxes are owed. Important note here–the taxable value of your estate may be different than the value of your probate estate, so don’t assume they are the same, do the calculations.
- What is “portability?” Current estate tax law allows for “portability” of an unused portion of the estate tax exemption. Essentially, it allows an unused portion of one spouse’s exemption to be transferred to another spouse so long as the right paperwork is timely filed. For example, if a husband passed away in 2016 with a $2 million estate, there would be $3.45 million of estate tax exemption remaining. Portability would allow that remaining amount to be transferred to his wife and added to her $5.45 million, making her total exemption $8.9 million. In order to qualify for portability, the decedent’s estate must file a Form 706 with the IRS within 9 months of the person’s death. Keep in mind that portability exists now, but it may not be permanent, as Congress could always change the law regarding this in the future.
- What should I do if I think my estate might be close to the $5.45 million exemption? If the federal estate tax might be an issue, it is critical that an attorney and accountant be consulted to determine if, in fact, the estate tax will likely apply to the operation and to evaluate possible strategies to avoid the hefty 40% tax bill that would come with the estate tax application, or to make a financial plan for how the estate will be able to afford to pay these taxes when they come due. Simple strategies could make huge differences in the amount of money owed to Uncle Sam.