Hey there, welcome to my explanation about Federal Estate Taxes and Gift Taxes in the United States. I’ll break it down in a way that’s easy to understand.
Federal Estate Tax Overview:
The federal estate tax in the United States is a tax imposed on the transfer of a person’s estate upon their “death”. This tax is imposed on the total value of an individual’s assets and property at the time of their death. It’s important to note that not everyone is subject to the federal estate tax; Effective January 1, 2023, the federal gift/estate tax exemption and GST tax exemption is $12,920,000. This means if your gross estate is less than $12.92 million, you don’t have to worry about Federal Estate Taxes in the United States. You may still have to worry and plan about the State Estate Taxes, but let’s just focus on federal estate taxes today.
The lifetime “gift tax” exemption and the federal estate tax exemption are interconnected. People will be easily able to escape the estate taxes if there is no backdoor stop on gifts. If an individual with a $20 million estate can give a deathbed gift of $20 million without any gift tax consequences, they won’t have to worry about estate taxes. Hence, the government imposes a gift tax.
You get only one chunk of exemption, you can give it while alive or at your death! You get that limit of $12.92 million. Any portion of the lifetime gift tax exemption used during an individual’s lifetime reduces the federal estate tax exemption ($12.92 million) available upon death. If I give my friend $2 million today, my exemption of $12.92 will go down. But wait, there is something called annual gift tax Exclusion, which creates room for planning. In 2023, an individual can give up to $17,000 to any number of recipients without incurring federal gift tax. This is known as the annual gift tax exclusion. For example, if I have three children, I could give each of them $17,000 in cash or assets in 2023 without paying any federal gift tax. But if I give someone more than $17,000 a year, it counts against $12.92 million limit. So, if you gave a gift of $20,000 to one person in 2023, $3,000 of that amount would count against your lifetime exemption. You don’t owe taxes in the year you gave that $20k, but you must file a gift tax return, which is form 709. When you die and if you die with more than $12.9 M that $3,000 will go towards that amount. Meaning, you used that amount during your lifetime.
Tax Rate: If your estate is worth more than the limit, you might have to pay around 40% in taxes on the extra. OUCH!!
Let me talk about good stuff now: deductions and credits! There are some things you can subtract from your estate’s value, like debts, funeral costs, donations to charity, and leaving your estate to your US citizen spouse. This can lower the amount you’re taxed on. The marital status of a person can be a game changer. If your spouse is a U.S. citizen, you can leave everything to them when you pass away, and there won’t be any federal estate tax. You can make unlimited lifetime gifts without any gift tax consequences. But, at the time of the second death, the surviving spouse’s estate will get taxed if it’s over $25.84 million. How did that amount get doubled? You not only get to use your own $12.92 million deduction but also your spouse’s unused deduction. This concept is called ‘portability’.
Let me put this into a hypothetical to make it understandable. Let’s say John and Mary are both U.S. citizens, and they’re married to each other. John has $20 million in his stuff. If he passes away first and leaves it all to Mary, no tax is due because U.S. citizen spouses are exempt from federal estate tax. However, when Mary passes away, her estate might get taxed if it’s over $25.84 million. She can use John’s unused $12.92 million exemption, but if she doesn’t spend over $25.84 million, her estate will pay a 40% tax on the extra.
Now, the Tricky Part – Non-U.S. Citizen Spouse! Things change if the surviving spouse isn’t a U.S. citizen, even if they have a green card. In 2023, a U.S. citizen can gift up to $12.92 million during their life or at their death to anyone, including a non-citizen spouse. But if the spouse is not a U.S. citizen, there’s no unlimited spousal deduction. In 2023, annual gifts to a non-citizen spouse are limited to $175,000.
How can we get the unlimited spousal deduction for a non-US citizen spouse? There are two exceptions:
1. If the non-U.S. citizen spouse becomes a U.S. citizen before filing the estate tax return. (Pretty intuitive!)
2. If the property going to the non-U.S. citizen spouse passes into a Qualified Domestic Trust (QDOT).
Qualified Domestic Trusts (QDOT):
A QDOT is a special trust that meets certain rules:
– It must have at least one trustee who is a U.S. citizen or a domestic corporation.
– The trustee must have the right to withhold taxes from distributions.
– The surviving spouse can make an election to treat the trust as a QDOT, and once they do, it’s permanent.
– The trust must be created before the estate tax return’s due date.
– If the QDOT holds more than $2 million, one trustee must be a U.S. bank and might need to post a bond or letter of credit.
Back to John and Mary: If Mary is a U.S. permanent resident (not a citizen) and she dies leaving her $14 million to John, her death won’t trigger estate tax. But if John, the U.S. citizen, dies first and leaves more than $12.92 million to Mary, there might be an estate tax bill unless her assets are protected in a QDOT.
That’s the basics of how federal estate and gift taxes work. It’s always a good idea to consult with a tax professional to discuss your specific circumstances. There is no “one size fits all” approach when it comes to legal matters.