An explanation of Federal Estate Taxes in plain English [Part I]

The goal of this series is to help you understand when you might want to plan to minimize Federal estate taxes. You need to understand what the IRS considers your “gross estate”, “fair market value”, when you could owe federal estate taxes and what you can do to minimize the amount of taxes you would pay if any are owed.

What is your “Estate”?
The “Estate” consists of everything you own or have an interest in at the time you die. The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your “Gross Estate.” It is the value of your “gross estate” on which you will be taxed.

The property may include a lot of different things like cash and securities, real estate, insurance, trusts, annuities, business interests and other assets. You may have heard about the distinction between “probate” (property that the Court has control over) and “non-probate” property (property that passes outside of the court process). Forget that distinction for federal estate tax purposes, the IRS looks at everything and this usually means non-probate as well as probate property.

What is “Fair Market Value?”
Fair Market Value is generally the price at which the property would sell if two normal people were doing a transaction that didn’t involve any really unusual circumstances. For example, the IRS says that fair market value can’t be a “forced sale price”, something like the price for property at a foreclosure sale. Essentially, fair market value comes down to what someone would sell an item for on Craigslist to a buyer that understood what he was buying and was willing to pay for it.

Who is going to owe Federal Estate Taxes?

The answer is anyone who dies with an estate larger than the exemption amount. However, if anyone can answer this question with certainty, be very suspicious of them. The problem with specific answers is that federal estate tax rates and exemption amounts change regularly, often depending on which political party controls Congress. A person who dies this year (2012) with more than a $5.12 million exemption number in “assets”, will likely pay federal estate tax at a rate of 35% on the amount over the exemption.

Keep in mind that Federal taxation rates/exemption amounts could change as they have over the last ten years: in 2005 the exemption amount was $1.5 million, in 2012 the exemption amount is $5 million. For 2010 there was supposed to be zero estate tax but Congress changed the law on December 17, 2010 and made it $5 million. Plus, are you able to predict today how much property you will have when you die or when you will die? I am thinking the answer to both questions is negative.

Are you wealthy enough to pay taxes?

If you think you are not, you might be surprised. Your “taxable estate” includes “EVERYTHING”, even life insurance (commonly believed to not be subject to taxation.)  Consider this example:

• You own a home worth $300,000.00.
• You own another vacation home or a small business worth $200,000.
• You and your spouse have IRAs, 401(k), Bank CDs and Annuities totaling another $500,000.00.
• You have life insurance policies worth $1,500,000.00.

You have a total taxable estate of $2.5 million. Not a problem . . . as long as you die in 2012. However, if you die in 2013 when the exemption is slated to go down to $1 million per person, you will have federal estate tax issues.

The point is, there simply is not a lot of certainty in federal tax law (other than, of course, if you owe, you will have to pay it). For that reason, if your assets are anywhere close in value to the upper exemption limits, you should take some precautions to minimize what you might pay.

Come back tomorrow for Part II of this blog post series to to find out how to:

minimize the taxes you might owe

Posted by Shawn Roberts

On this blog, I write about and try to answer practical Oklahoma legal questions. My focus and most experience is in estate planning and business issues including Oklahoma non-compete law. I make a living as an attorney in the law firm I founded, Shawn J. Roberts, P.C. in Oklahoma City. I live in Edmond with my wife Amy and my two children, Sam (19) and David (11). We live precisely in the path of where the "wind comes sweeping down the plains."

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[…] Part I of this series, I started by talking about the basics of Federal Estate taxation, including the […]