Roger was devastated to hear about the passing of his grandfather. The two were close when he was a boy, but now he had a family of his own now and lived on the other side of the continent. The Recession sent Roger’s financial situation went into a free-fall when his employer closed in late 2009. Roger was running out of savings quickly, and attempting to make ends meet with a collection of part-time jobs held between he and his wife was not meeting the need.
Roger was notified that he was named in his grandfather’s will. His grandfather had amassed a significant estate over the years. Roger thought this might be the solution to his financial problems. A friend warned Roger that he would probably face an inheritance tax. Roger was not familiar with the inheritance tax and contacted his grandfather’s attorney for more information. He was relieved to learn that his grandfather named him as part of a trust and he was exempt from the inheritance tax.
One of the best ways to avoid an inheritance tax, also known as the estate or “death” tax, is to create an estate plan that includes trusts. The estate tax prior to 2001 assessed a 55% tax on estates valued at $1 million. Recipients were often required to sell the inheritance to pay the tax. The Bush tax cuts in 2001 increased the assessed value baseline and lowered the tax rate progressively through 2010. The tax agreement reached in 2010 to prevent the estate tax from reverting to pre-2001 levels did accomplish that goal. However, those with estates valued over $5 million need to consult tax professionals for new rules that came into play with the agreement.
The design of the trust is critical in avoiding inheritance taxes. The design of trusts includes property ownership, a three-year “look-back” rule, and the revocable nature of the trust. Property ownership applies to transfers of property while the grantor retains primary use and control over the property. The IRS will typically include such property in the calculation of estate value for the deceased. Property included in the trust but with strings attached or subject to revoke by the grantor will typically be included in calculating the value of the estate.
One way to avoid the property ownership pitfall is to abide by the three-year “look-back” rule. The key element is to make sure ownership and control of the property are moved to the trust at least three years prior to the grantor’s death. The primary focus is financial resources included in the trust. This rule was designed to prevent deathbed transfers of property such as life insurance policies for avoiding taxes.
Another way to strengthen trusts in order to avoid inheritance tax is to form an irrevocable trust. An irrevocable trust makes the grantor a trustee with limited powers. The grantor is restricted from accessing the funds once the trust goes into effect except for educational or medical purposes for the benefactors of the trust. This transfer of funds would need to occur at least three years prior to the death of the grantor in order to avoid taxes implications. Tax policies can change so the decision to transfer these funds should only occur after discussing the situation with tax professionals.
The key to avoiding the inheritance tax is to estate plan carefully and with the assistance of tax professionals. Trusts provide the primary method for avoiding the inheritance tax and generally mitigate arguments over the will after the grantor’s death. The key factors to remember in creating a trust are to plan early, to plan thoroughly, to monitor the trust once created, and to trust that the trust will do what it was designed to do.