According to the U.S. Securities and Exchange Commission (SEC), a high net worth individual has $750,000 in revenue or a $1,500,000 net worth. When you hit this financial level, tax planning becomes essential.
Because, not only do you need to create a plan to minimize income tax, you also need to consider four other types of tax that can impact your estate.
Federal and State Estate Tax
Most relatively simple estates do not require the filing of a federal estate tax return. In 2021, a filing is required for estates with combined gross assets and prior taxable gifts exceeding $11,700,000 ($28,400,000 for married couples).
The $11,700,000 is termed the lifetime exemption. The lifetime exemption fluctuates depending on the tax law in place. In 2008, the exemption for a single taxpayer was $1,000,000. In 2015 the exemption was $5,430,000.
When your estate exceeds the lifetime exemption, the assets in your estate are subject to an estate tax as high as 40%. This is separate from your income tax. It is possible to owe both income and estate tax upon your passing. To reduce estate tax, high net worth individuals can move items out of their state with trusts and gifting. These individuals should consult an Estate Planning Attorney and a CPA to develop the best strategy to minimize estate tax and effectively pass on generational wealth.
States have their own estate tax laws as well. More than ten states implement an estate tax. Often, the estate value subject to tax is much lower than the federal amount. Oregon, for example, applies estate tax threshold start at only $1,00,000. States such as California and Florida do not subject estates to any tax.
Generation-Skipping Tax (GST)
Some high net worth individuals plan to leave assets to their grandchildren to prevent their direct children from being subject to an estate tax on their inheritance. The IRS imposes a tax on these transfers that skip a generation. The tax is called a generation-skipping tax (GST). The GST applies to assets gifted to a "skip person." According to the IRS, a skip person is:
A natural person assigned to a generation that is two or more generations below the settlor's generation, or
A trust that meets either of the following conditions:
All interests in the trust are held by skip persons; or
No person holds an interest in the trust, and at no time after the transfer to the trust may a distribution be made to a non-skip person.
Similar to the estate tax, the GST is also subject to exemptions. Estate and trust tax planning can help you reduce or eliminate GST on your estate.
High net worth individuals that try to avoid estate tax by gifting away all of their wealth could subject themselves to the Gift Tax.
According to the IRS, a Gift is any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return. The general rule is that any Gift is a Taxable Gift. However, there are many exceptions to this rule. Generally, the following Gifts are not Taxable Gifts:
Gifts that are less than the annual exclusion for the calendar year. In 2021, the annual exclusion is $15,000 per gift. This means that gifts less than $15,000 are not subject to the Gift Tax. Taxpayers who gift more than $15,000 might be required to complete a Gift Tax Return.
Tuition or medical expenses you pay for someone (the educational and medical exclusions).
Gifts to your spouse.
Gifts to a political organization for its use.
In addition to this, Gifts to qualifying charities are deductible from the value of the Gift(s) made.
Taxable Gifts are subject to an annual exemption amount. Gifts that exceed the annual exemption are subject to a tax rate as high as 40%. In 2021, taxpayers that give more than the $11.7 million exemption (double if married) over their lifetime will be subject to the tax. So, even though you might have to complete a Gift Tax Return for a gift over $15,000, you might not be subject to the Gift Tax if the total value of your lifetime gifts is less than the annual exemption.
Whew, that's a handful!
If you are concerned about the Gift Tax, discuss alternative wealth transfer options with your estate planning attorney and CPA.
Trust Income Tax
Income held within a trust might be subject to income tax. The taxable nature of a trust depends on the type of trust, trust distributions, state laws and other factors. If you are the grantor, trustee or beneficiary of a trust, reach out to a CPA to understand the federal and state tax requirements for your trust.
Since estate tax planning and trust tax preparation requires knowledge beyond the IRS tax code, you should only hire a CPA that specializes in estate and trusts for tax planning and return preparation. Your CPA should have knowledge of your state's uniform principal and income act, as this governs trust tax reporting. For more information on trust tax planning and preparation, contact me.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, investment or accounting advice. This information is not endorsed by a financial institution. You should consult your own tax, legal and accounting advisers before engaging in any transaction.