Be aware of current laws on estate taxes

If you have been thinking about estate taxes as long as I have, then you remember the estate tax exemption of $600,000 per person.

Twenty-five years ago, many more people than today had to consider the “death tax.”

A lot of families had separate trusts for Mom and Dad in an effort to double the rather low exemption. Many farmers would be in trouble today if the exemption were still that low, considering that some 40-acre fields are worth more than $600,000.

During the past 20 years we have seen the estate tax exemption rise all the way to $12.06 million for 2022. That's been good news for farmers and millions of small-business owners.

In addition to the increased exemption amount, a spouse can now elect to receive the unused portion of a spouse's exemption (called portability). If one spouse passes away with $7 million in assets, the surviving spouse's exemption can expand to include the unused $5.06 million.

All this adds up to most people not having to worry about estate taxes.

An April 2021 report by the USDA Economic Research Service said that less than 1% of farm estates owed estate taxes in 2020. Yet, for those farms in which the tax is applicable, estate taxes can still be burdensome.

Taxable estates get hit with 40% of their taxable assets above $1 million. So, individual estates in 2022 worth more than $13.06 million will pay a marginal estate tax rate of 40%, unless existing tax laws change.

The Tax Cut and Jobs Act, which went into effect January 1, 2018, basically doubled the estate tax exemption, and the expiration of that provision is currently set for the end of 2025. However, some lawmakers are eager to get those revenue-producing estate taxes ramped up earlier.

The Build Back Better Act (BBBA) passed the House in November. Though it is unknown at the time of this writing which, if any, provisions will pass the Senate, the House bill calls for the estate exemption to come back down to $5 million, indexed for inflation, effective January 1, 2022. That amount is estimated to be around $6 million per person.

Effects on other strategies

The BBBA could eliminate one strategy for getting assets out of a taxable estate: The government may start including assets a deceased person has put into a grantor trust. That would apply only to trusts created after enactment of the BBBA or to contributions made after the date of enactment to existing grantor trusts.

The BBBA also proposes eliminating valuation discounts for lack of control or lack of marketability that are attributable to cash or marketable securities held by LLCs and partnerships.

The gradual gifting of small ownership portions of family LLCs is a strategy that tax attorneys and CPAs have been using for many years. The point of it is to get assets out of a potentially taxable estate. Because of gift tax reporting and estate exemption limits, the discounting of minority interests can allow the transfer of ownership to happen in larger percentages or faster. It makes each minority owner's interest look less valuable. Basically, the sum of the parts of a family LLC have been allowed to add up to less than the whole, and the government would like to end that.

Reporting, estate taxes interaction

The interaction of gift tax reporting and estate taxes is widely misunderstood. Most people think that if they give away more than $16,000 (the new 2022 limit), someone will owe some kind of tax on it. Not so, unless you give away over $12 million in your lifetime.

The $16,000 per year threshold is simply the point at which you have to report the gift to the government. The IRS then reduces your lifetime estate tax exemption by the reported gift amount. Hence, if you report a $200,000 gift to your child, your new estate tax exemption amount is $12.06 million less $200,000 or $11.86 million for 2022. So don't fear gift tax reporting.

Eliminating stepped-up basis

At one point last year the Biden administration suggested eliminating the stepped-up basis provision of the tax code. Stepped-up basis allows heirs to inherit assets, such as land, at the fair market value on date of death. This then allows heirs to sell their interest with no capital gains tax, provided the sale happens soon after death. Many years down the road the property value can increase substantially, causing capital gains tax on the increase since the date of death.

If stepped-up basis were eliminated, heirs would receive carry-over basis. That means whatever mom and dad paid for the land would become the basis for the heirs.

After pushback from farmers and rural lawmakers, the proposed elimination was eliminated.

A proposal also was floated at one point last year to tax inherited property above $1 million at the time of death. That idea was also scrapped.

Another revenue raiser discussed last year by the House Ways and Means Committee was the elimination of the 1031 exchange. The 1031 exchange allows you to defer capital gains tax on a property by exchanging it for a similar investment property, such as one farm for another. The tax-deferred exchange is a big component of the flow of capital in the real estate investment community, including farm investors. Losing it would have been a major disruption to the real estate market, in my opinion.

Other related proposals floated in 2021 were the idea of limiting deferred 1031 capital gains to $500,000 in a given year and increasing the maximum capital gains tax rate from 20% to 39.6%. None of those proposals have made it into law, at least not yet.

States with estate tax or inheritance tax:

State tax implications

When gurus talk about estate taxes, they often miss an important point — escaping federal tax does not always mean you escape state estate taxes. Seventeen states have estate or inheritance taxes. Some state exemption levels are only $1 million, or even $0 in certain situations. If you live in one of those states, figure out exactly what the exemption levels are and the applicable tax rates.

You may not need to live in the state for the estate tax to apply. Many people are surprised to hear they owe some Illinois estate tax, even if they've never set foot in Illinois. If you have any real estate in Illinois and at least $4 million somewhere in the United States, you will owe something.

For example, if you have $4 million in Florida and inherited a $10,000 parcel in Illinois, you will owe a bit of Illinois estate tax. The state, like several others, is decoupled from the $12 million federal exemption.

I have prepared a few estate tax returns in the past couple of years involving farms, and in all cases the estate did not owe federal estate taxes but did owe state estate tax; a topic for a future article.