Many estates can save money by filing tax returns – even if they don’t have to

And people with older wills should have them reviewed now, due to a new law from Congress

A federal estate tax return doesn’t have to be filed every time someone dies. In fact, most estates never have to file one. In 2011 and 2012, a return has to be filed only if the person’s estate (including property, life insurance, taxable gifts, etc.) is worth $5 million or more.

However, even if a return isn’t required, a recent change in the law means there could be big tax savings for many families if they file one anyway.

The change applies to estates of people who die in 2011 or 2012 and are survived by a spouse.

There are strict time limits for filing a return, so if you know of someone whose family could take advantage of these savings, you or they should speak with an attorney right away.

Also, if you have an older will that includes a trust designed to reduce taxes when a surviving spouse later dies, you should have the will reviewed, because under the new law there might now be better alternatives.

How it works

Generally, when a person dies, his or her estate can give an unlimited amount to a surviving spouse. After that, if the person’s bequests (plus large lifetime gifts) total more than a certain “exemption amount,” then an estate tax is due. For 2011 and 2012, the exemption amount is $5 million.

Traditionally, the exemption amount applied separately to each spouse. So if a husband died first, his estate could use the exemption amount, and when his wife died later, she would get her own exemption amount.

But under a change in the law starting in 2011, if the first spouse to die doesn’t use all of his or her exemption amount, the difference can be passed along to the other spouse. So suppose a husband dies and doesn’t use any of his $5 million amount (because he leaves everything to his wife). When the wife dies, her exemption amount will be her own $5 million plus the $5 million that the husband didn’t use. So instead of being able to leave $5 million tax-free to her heirs, she can leave $10 million tax-free – a potential savings of millions of dollars.

However, this only works if the husband’s estate filed an estate tax return and elected to pass the exemption amount on to his wife. If the husband’s estate didn’t file a return (because it wasn’t legally required), then all the potential tax savings are lost.

This means that it’s almost always a good idea to file an estate tax return for anyone who dies in 2011 or 2012, if they are survived by a spouse.

Even if it seems highly unlikely that a surviving spouse will be worth more than $5 million when he or she dies, it’s still a good idea to file a return, because the $5 million exemption amount only lasts through 2012. After that, Congress can change it, and we don’t know what amount Congress will choose. It appears that if Congress doesn’t do anything, the amount will be reduced to just $1 million in 2013.

Because the current law only lasts through 2012, there are a lot of questions and uncertainties about what will happen after that. It’s possible that the law will change again, and the tax savings may be reduced or lost by the time the surviving spouse dies. However, in most cases, the cost of filing an “unnecessary” tax return will be small compared to the potentially huge savings down the road.

(In a few cases, executors might be put in an awkward position because the heirs who would have to pay for filing the return might be different from those who would benefit from the increased exemption. In such a case, the executor might want to ask the surviving spouse to pay the cost of the filing, since he or she will benefit from it.)

Many wills need to be reviewed

In the past, many people tried to achieve a similar result – using both spouses’ exemptions – through the use of a trust, sometimes called a “bypass trust.” Typically, when the first spouse died, some of his or her assets (often a sum equal to the current exemption amount) went into a trust, and the rest was left directly to the surviving spouse. The trust might pay income and principal to support the spouse during his or her lifetime, after which the assets would go to children or other heirs. When the surviving spouse died, the trust property wasn’t included in his or her estate, and so it didn’t “count” toward the exemption amount.

A new law means that it’s almost always a good idea to file an estate tax return for anyone who dies in 2011 or 2012, if they are survived by a spouse.

The new law might make these kinds of bypass trusts unnecessary for some people – at least until the end of 2012.

You might want to consider the costs and benefits of eliminating such a trust from your will, or at least providing that the trust provisions won’t take effect unless the law changes again such that the trust becomes a good idea.

Some of the disadvantages of a bypass trust include:

• The surviving spouse has less flexibility and access to the assets.
• There are expenses in managing the trust, filing trust tax returns, and sometimes hiring an outside trustee.
• If trust property is sold after the surviving spouse dies, the “basis” for capital gains tax purposes is its value at the time of the first spouse’s death – whereas without a trust, the basis would be the (presumably higher) value at the time of the second spouse’s death.

On the other hand, there are some powerful reasons to keep a bypass trust. For instance:

• Assets in such a trust will be protected from a surviving spouse’s creditors, and from the actions of a future spouse if the surviving spouse remarries.
• A spouse might want to put property in a trust to make sure that when the surviving spouse dies, the assets will go to the person’s children from a prior marriage.
• A bypass trust can also reduce state estate taxes, as well as generation-skipping transfer taxes.
• A bypass trust shields all future appreciation from estate taxes – even if the assets in the trust grow in value far beyond the amount of the first spouse’s exemption.

As an aside, if your old will says that the amount that will go into a bypass trust is equal to the exemption amount, you might want to review this in light of the fact that the exemption amount in 2011 and 2012 has been dramatically increased to $5 million. You might prefer to say that the trust assets will be the exemption amount or a certain dollar figure, whichever is less.

Remarriage

One final note: If a surviving spouse “inherits” the other spouse’s unused exemption, it’s not clear what happens if the spouse remarries. While the law is confusing, it appears that if the spouse remarries and then the new spouse dies first, the unused exemption from spouse #1 is wiped out, and the spouse is limited to any unused exemption from spouse #2.

This is something that spouses who are considering remarrying will want to take into account in their estate planning. The issue of “inherited” exemptions is also something that they might want to specifically provide for if they are going to sign a prenuptial agreement.

Some states now allow you to ‘win’ a will contest … while you’re still alive

People are sometimes concerned that after they die, a beneficiary (or more likely a non-beneficiary) will go to court to contest their will. Typically, a disgruntled would-be heir might claim that the person who made the will wasn’t mentally competent, or was under undue influence from some other person. These types of will contests can be very expensive, and they can cause a lot of emotional hardship within a family.

Recently, a handful of states have allowed people who make a will to go to court while they’re still alive and have a judge rule that the will is valid – thus preventing a will contest.

These states include Alaska, Arkansas, Nevada, North Dakota and Ohio. Similar legislation is pending in Delaware.

Even if you don’t live in one of those states, you might be able to obtain a court ruling there, such as by putting your assets into a revocable trust and hiring a trustee in that state.

Of course, there are many drawbacks, including the inconvenience and expense, the fact that you’ll have to make your estate planning documents public before you die, and the fact that if you later revise your estate plan, the ruling will be worthless and you’ll have to start all over again.

If you’re truly concerned about a will contest, this idea might be worth exploring. But there might also be other, less drastic methods of making sure that your intentions are carried out.

Gifts made in 2012 can reduce state estate taxes

Some 22 states have a state estate tax or a state inheritance tax. These taxes are in addition to the federal tax. For some people, it’s possible to reduce or eliminate these state taxes by making gifts before the end of 2012.

Ordinarily, you can give up to $13,000 each year to as many people as you like without paying gift tax. Through the end of 2012, you can also make total lifetime gifts in addition to these amounts of up to $5 million. You won’t have to pay gift tax on these additional lifetime gifts, although they will reduce your estate tax exemption when you die.

That means that if you make gifts before the end of 2012 of up to $5 million (such as, for instance, gifts to trusts that will benefit your children), it will have a neutral effect on your federal estate tax – your estate won’t owe more or less as a result.

By making lifetime gifts rather than bequests in a will, you may be able to lower or even eliminate the amount of state estate taxes that will be owed.

However, it can have a very positive effect on your state estate tax. By making lifetime gifts rather than bequests in a will, you’ll reduce the amount of your taxable estate, which can lower or even eliminate the amount of state estate taxes that will be owed.

If you live or own property in a state that has a state estate or inheritance tax, this is a strategy you might want to consider.

This newsletter is designed to keep you up-to-date with changes in the law. For help with these or any other legal issues, please call today. The information in this newsletter is intended solely for your information. It does not constitute legal advice, and it should not be relied on without a discussion of your specific situation with an attorney.