Making it even less likely that this tax will have an impact, gifts between spouses are unlimited, and certain gifts to others, such as payments for directly-paid tuition or medical expenses, are not counted as gifts.
Any direct gift to anyone other than your spouse is “taxable” to the extent they exceed the $15,000 annual exclusion amount and must be reported on a U.S. Gift Tax Return (Form 709), even though the gift may not be taxable due to the $11.4 million exemption.
So, if the estate and gift tax will not come into play for most of us, how could the higher limit leave our heirs paying more tax? The catch is in how your estate plan is set up. The estate tax exemption used to be much easier to breach for anyone with a house, life insurance and a modest retirement savings.
Consequently, estate plans were commonly designed to avoid the estate tax by using a revocable living trust with a “credit shelter” or “bypass” trust provision. This setup ensured that a deceased spouse’s estate tax exemption would be fully utilized to reduce the estate tax impact.
Instead of leaving all assets outright to a spouse, the credit shelter trust sent enough assets to use up the deceased spouse’s exemption to a trust that could support the surviving spouse by providing income and certain amounts of principal, but not giving the spouse full access to the funds.
This way, the money in the “bypass” trust would not be included in the surviving spouse’s estate. If left outright to the spouse, no estate tax would be due, but the assets, and any growth, would be taxable at the second spouse’s death, without the ability to use the first spouse’s estate tax exemption.
We now have a higher estate tax exemption and the exemption is portable between spouses, allowing a married couple to pass $22.8 million to heirs tax-free. That’s great, but many estate plans still include revocable trusts that call for some assets to pass to a credit shelter trust at the death of the first spouse. This is where the higher tax bill for heirs can come into play, but it is an income tax bill, not an estate tax bill.
When assets are transferred from an estate, the beneficiary’s cost basis for determining taxable gain or loss becomes the value of the assets on the date of the decedent’s death. This can mean a considerable tax savings if the assets had appreciated significantly in value.
Appreciated assets passing to a credit shelter trust receive a step-up in basis at the death of the original owner, wiping out any taxable gain at that point, but they will not receive a step-up in basis when the second spouse dies because they are not part of his or her estate. The estate tax was avoided on these assets on the second death, but the beneficiaries might have been better off if the assets were left outright to the spouse to take advantage of a second basis step-up.
The key here is that any trust documents you have should be reviewed to see if they still make sense given the higher estate tax exemption. Plans designed to minimize the estate tax should be revisited to ensure that they minimize income taxes the beneficiaries might pay given the new estate tax exemption amount.
There may be good reasons to keep the credit shelter trust language in place, perhaps with a revision to the formula determining the size of the credit shelter trust that gives the trustee some flexibility to adapt to changing tax laws, but planning might be better focused on minimizing capital gains tax for heirs rather than estate tax.