Introduction: My husband passed
earlier this year. He left everything directly to me. The attorney
helping tie up all the loose ends is recommending that I file a
Federal Death Tax Return. He says there will be no death taxes
owing. It seems to me this attorney is just trying to get an extra
$5000 out of this widow.
I did some checking. The death tax return is only required if my
husband had more than $5 million to his name. Our total net worth
was $4 million. So his half would have been $2 million. No return
Whatís going on? Should I call the attorney to task on this?
Widow Not Wanting to be Taken!
Death Tax Return: The law can
be confusing and even counter intuitive at times. First, the death
tax return to which you refer is technically called the Estate Tax
Return (or form 706). But we will refer to it here as the Death Tax
Return because that seems to be less confusing to most people.
Filing Requirements: One is
required to file the return if the gross estate is over the estate
tax exemption. Although we talk about a $5 million exemption,
actually that exemption changes dependent on the year of death since
the exemption is tied to an inflation factor. In 2012 the exemption
was $5,120,000 and in 2013 it is $5,250,000. Note also that the
estate value is based on the gross value, not the net value. That
means its value is without deduction for debts and mortgages. Before
our other readers get up in arms, the tax calculation takes into
account the debts and mortgages but the filing requirement does not.
Reasons for Filing a
Return: Ok, on to your problem: is this attorney trying to take
you to the cleaners? Probably not as there can be good reasons for
filing the Death Tax Return.
Appreciation: Ever hear of inflation? And real estate
appreciation; especially in California. You say that your husband
left everything to you so I am going to assume that an A-B Trust was
not involved. That means that when you pass, everything in your own
half of the estate plus what your husband left you (his half) will
be subject to the death tax. Plus, assuming that the income from the
$4 million estate allows you to not dip into principal for living
expenses, it will probably be more than it is worth today due to
inflation and appreciation. You might be worth well more than
whatever the exemption is at that point in time. If that is the case
then anything over the exemption amount will be subject to the death
tax, currently at a rate of 40%.
Letís take an example. For simplicity, we will ignore the exemption
inflation factor and just assume it is a flat $5 million. If your
estate appreciates to $6 million at the time of your death then the
death tax taken from your childrenís inheritance will be $400,000
($6 million estate minus $5 million exemption times 40%). If it
appreciates to $7 million then the tax will be $800,000.
Marital Deduction: But hereís
the kicker. Where a decedent leaves anything directly to the
surviving spouse, a deduction for death tax purposes is allowed for
the value of what is left to the spouse. In your case all $2 million
of your husbandís assets were left to you. So hereís the death tax
calculation: gross estate of $2 million minus the deduction
(technically called the marital deduction) of $2 million leaves a
taxable estate of $0. No estate tax exemption needs to be used to
reduce the tax since there is no tax in the first place.
Unused Exemption: That little tidbit is important. Hereís why.
You can transfer over (or port) your husbandís unused death tax
exemption to yourself, i.e. itís portable. This is called the
Deceased Spouse Unused Exemption (DSUE). So instead of his unused
exemption evaporating, it can be used when you die. Essentially you
now have a $10 million exemption. His unused $5 million (or whatever
the inflation factor increased the exemption to when he died) and
your $5 million. The inflation factor continues to apply to your $5
million. Depending on the value of your estate when you die that
extra $5 million that you received from your husband can be worth $2
million ($5 million times 40%) to your children.
Capital Gains: Another reason it
may be important to file a death tax return. Assuming you do have an
A-B Trust, the assets in the B Trust typically do not obtain a step
up in basis for capital gains income tax purposes on your death.
What are we talking about here? If you buy something for $10,000 and
sell it for $100,000 you have a profit (the IRS calls it a capital
gain) of $90,000 and potentially you pay income tax on that.
Combined Federal and California tax might be 30-35%. Thatís
approximate $30,000 (90,000 times 33%) in taxes. But if you die
before you sell it the asset obtains a new basis (or starting point)
equal to the fair market value at the date of death. If it is worth
$100,000 at that time, then its basis is $100,000. If your children
then sell it for $100,000 their capital gain for tax purposes is 0
and they pay no capital gain tax. Another way of saying this is that
the IRS forgives the predeath appreciation.
Qtip Election: All well and good,
but how do we apply that principle to the assets in the B Trust.
After the first spouse dies, a tax election can be taken to tell the
IRS that you want the B trust to focus on income tax savings rather
than death tax savings. After all, if there is enough death tax
exemption available (especially with the DSUE) to cover the
projected value of the entire estate when you die, then why worry
about death tax? This is called the Qtip election. With this
election in place, the assets in the B Trust are allowed to obtain a
step up in basis on your death.
Projections: In order to make an
intelligent decision, certain projections have to be made: your life
expectancy and future appreciation certainly play into this.
Obviously, if a surviving spouse has $1 million total, has little
hope of any significant appreciation, does not play the California
lottery, did not have an A-B Trust with her spouse, and has a short
life expectancy, it would seem somewhat silly to file a death tax
return for the deceased spouse.
Taxes, both death and income (including capital gain) are issues
that always need to be explored when one dies. And consulting with a
competent attorney (see explanation of the California Specialist
Certification program) is highly advisable.