For many people, the new $5.34 million applicable exclusion amount is more than adequate to avoid the federal estate tax. But, if you transfer more than $5.34 million upon your death, you will be taxed at the estate tax rate of 40 percent.
Moreover, the new federal estate tax exemption does not apply to state estate taxes. Many states, including Connecticut, impose a separate estate tax. The Connecticut applicable exclusion amount is only $2 million. Thus, if a taxable estate exceeds $2 million, a Connecticut estate tax will be due. The Connecticut estate tax rate ranges from 7% to 12% depending on the amount above the Connecticut estate tax exclusion. So for example, a $2.5 million taxable estate would owe approximately $36,000 in Connecticut estate taxes (this is a simplified calculation not accounting for administration expenses and assuming no lifetime taxable gifts).
Due to the low state exemption amount, many Connecticut residents should take steps to avoid estate taxes. The following is a brief overview of two trusts that can help you avoid estate taxes.
Irrevocable Life Insurance Trusts (ILIT)
Did you know that the value of the death benefit of your life insurance policy will be included in your taxable estate even though your policy pays directly to beneficiaries and bypasses your probate estate? For example, a $1 million life insurance policy made payable to your spouse still becomes part of your taxable estate. A large policy like this could easily push many estates into the taxable bracket.
The good news is you can exclude the entire amount of your life insurance policy by transferring ownership to an Irrevocable Life Insurance Trust (“ILIT”) or buying a new policy in the name of an ILIT. You will need to name the ILIT as the owner and beneficiary of the life insurance, but you can name your spouse as a lifetime beneficiary of the Trust with a remainder to your children or grandchildren. You can use an ILIT to establish an education fund for your children or grandchildren, or to fund the buy-out of a business. Each premium payment is a gift for gift tax purposes so a gift tax return may be due if the premium exceeds the $14,000 per person annual gift tax exclusion or if beneficiaries do not have the right to withdraw any trust contributions used to pay the premiums. An ILIT can be an effective tool for transferring wealth to your spouse or your descendants tax free.
Credit Shelter Trust to combine exemptions of married couple
Another tax saving trust is commonly referred to as the Credit Shelter Trust. Each spouse has his or her own estate tax exemption or credit. By combining their exemptions, spouses can shelter a combined $10.68 million for federal and $4 million for Connecticut purposes. Spouses also have the benefit of the unlimited marital deduction. The marital deduction allows the tax free transfer of assets of any amount between spouses. By combining both spouses’ estate tax exemptions with the use of the marital deduction, a couple can avoid estate taxation upon the death of the first spouse and shelter up to the full amount of both exemptions upon the death of the surviving spouse.
The new federal law makes the estate tax exemption "portable" between spouses. This means that if the first spouse to die does not use all of his or her $5.34 million exemption, the estate of the surviving spouse may use it. For example, John dies in 2014 leaving an estate of $3 million to his wife Mary. He has no taxable estate because of the unlimited marital deduction. His wife, Mary, can then pass on up to $10.68 million (her own $5.34 million exclusion plus her husband's unused $5.34 million exclusion) free of federal tax. Mary must make an "election" on John's estate tax return to take advantage of portability and preserve John’s unused exclusion.
Unlike the federal law, however, Connecticut law does not provide for portability of the estate tax exemption. The only way for a Connecticut couple to ensure the use of their entire combined $4 million estate tax exclusion is by using a Credit Shelter Trust.
A Credit Shelter Trust is designed to hold up to your remaining applicable exclusion amount. So, for example, John dies in 2014 and passes on $3 million to his wife Mary. Without a credit shelter trust, the entire $3 million could pass to Mary because of the marital deduction. However, John’s unused Connecticut exemption would be lost. If Mary died later that year, she would only have her own $2 million Connecticut exemption available to cover her $3 million estate. One million of her estate would be subject to estate taxation and Mary’s estate would owe approximately $72,000 in Connecticut estate taxes (this is a simplified calculation not accounting for administration expenses and assuming no lifetime taxable gifts).
Alternatively, John could fund a Credit Shelter Trust with $2million upon his death. This amount would be sheltered by his available $2 million exclusion amount. The remaining $1million could pass to Mary using the marital deduction. Upon Mary’s later death, she would only have $1 million in her estate, which she could cover with her $2 million exclusion. The balance of John’s Credit Shelter Trust will pass outside of her estate to their children without being reduced by estate taxes even if it grew beyond $2 million.
