Is Your Estate Tax Plan Out of Date?

Recent changes to the federal estate tax system now permit many more estates to avoid federal estate taxes altogether and also allow more effective income tax planning for children when they inherit at the time the survivor of Mom and Dad has died.  Also, while many states no longer have estate taxes, the estate tax systems in both Washington and Oregon are the same in structure as the federal estate tax system.  Because both states offer significantly lower exemptions than the federal system, planning to minimize the Washington or Oregon estate tax in conjunction with the larger federal estate tax exemptions requires some attention to detail.

The current federal estate tax system provides an exemption of $5.43 million per person.  Thus, a married couple can quite easily pass their combined estate of up to $10.86 million to children or other heirs completely free of federal estate tax.  Also, a very significant change in the federal law, referred to as “portability”, allows the unused estate tax exemption in the first spouse’s estate to be passed to the surviving spouse.  That is, if Dad passes away and leaves his estate to Mom, then under “portability”, Mom’s exemption can be $10.86 million.  There are some necessary actions required to claim this benefit in settling Dad’s estate at the first death, but they are quite simple.

However, while the state tax rates are lower than the 40% federal estate tax rate, neither Washington nor Oregon’s estate tax system allows for “portability” to the surviving spouse.  Thus, with the current Washington estate tax exemption per person at $2.054 million and the Oregon estate tax exemption at $1,000,000, intentional planning is still needed to “shelter” the state exemption in the first estate and thus protect it from Washington or Oregon estate tax in the survivor’s estate.

In the past, if the value of Mom and Dad’s estate exceeded the state exemption ($2.054 million Washington and $1,000,000 Oregon), a smart estate tax plan would shelter not only this value but any excess value up to the higher federal exemption (up to $5.43 million) by using a trust in the first estate (often referred to as the “shelter”, “credit”, “exemption” or “bypass” trust).  Before “portability,” this was very typical in connection with the federal estate tax.  However, today, the “smarter” approach would be not to carve out the excess in a trust at the first death, and also to allow the entire estate to be taxed in the surviving spouse’s estate for federal purposes.  That way, the survivor’s estate will receive a step-up in basis equal to the value of all the assets taxed at the time of the surviving spouse’s death, including those in in the estate of the first spouse to die.  This would permit the children to sell the assets with little or no income tax since the basis in the inherited assets would be stepped up to the value at the date of the death of the surviving parent.  If the value of the combined estates was less than $10.68 million, the estate would avoid all federal estate and income tax although state estate tax would apply to values in excess of the state exemptions but at much lower rates than either the federal estate or income tax rates.

If your Wills or Trusts were completed prior to 2011, the year when the federal estate tax exemption increased to $5 million (with increases in later years based upon an inflation index), and when the concept of “portability” was put into the federal estate tax law, then it is quite likely that you may have a mandatory and unnecessary “shelter”, “credit”, “exemption” or “bypass” trust that the surviving spouse will have to administer for life after their spouse’s death.  Such pre-2011 trusts are likely out of synch now with the greatly increased federal estate tax exemption.  Moreover, such a trust plan may not allow a step-up in basis at the surviving spouse’s death many years later which may result in a large built-in gain when their children or heirs sell the assets upon the termination of that trust.

So, even though Mom and Dad’s combined estates are much less than the current single $5.43 million exemption (in which case “portability” may not be necessary), or are less than the combined $10.86 million federal exemption, if the combined estates are more than the $2.054 million Washington exemption or the $1,000,000 Oregon exemption, then there is a reason to review and update your estate tax planning.  In many cases, you may be able to greatly simply your current plan which may be significantly more complicated than it needs to be (if your Wills or Trusts were done in the ’90s when the federal exemption was only $600,000).  Or, your plan may not be as flexible as it could be in order that income taxes can be avoided by your children or heirs at the time of the surviving parent’s death.