Why File a Death Tax Return by Choice?

Am I Being Cheated? Why Would I want to File a Death Tax Return If I Don’t Have To?

Introduction
Death Tax Return
Filing Requirements
Reasons for Filing a Return
Inflation and Appreciation
Marital Deduction
Deceased Spouse Unused Exemption
Capital Gains
Qtip Election
Projections
Qualified Specialist

Dear Mr. Miller:

Introduction: My husband passed earlier this year. He left everything directly to me. The attorney helping tie up all the loose ends is recommending that I file a Federal Death Tax Return. He says there will be no death taxes owing. It seems to me this attorney is just trying to get an extra $5000 out of this widow.

I did some checking. The death tax return is only required if my husband had more than $5 million to his name. Our total net worth was $4 million. So his half would have been $2 million. No return required.

What’s going on? Should I call the attorney to task on this?

Widow Not Wanting to be Taken!

Dear Widow:

Death Tax Return: The law can be confusing and even counter intuitive at times. First, the death tax return to which you refer is technically called the Estate Tax Return (or form 706). But we will refer to it here as the Death Tax Return because that seems to be less confusing to most people.

Filing Requirements: One is required to file the return if the gross estate is over the estate tax exemption. Although we talk about a $5 million exemption, actually that exemption changes dependent on the year of death since the exemption is tied to an inflation factor. In 2012 the exemption was $5,120,000 and in 2013 it is $5,250,000. Note also that the estate value is based on the gross value, not the net value. That means its value is without deduction for debts and mortgages. Before our other readers get up in arms, the tax calculation takes into account the debts and mortgages but the filing requirement does not.

Reasons for Filing a Return: Ok, on to your problem: is this attorney trying to take you to the cleaners? Probably not as there can be good reasons for filing the Death Tax Return.

Inflation and Appreciation: Ever hear of inflation? And real estate appreciation; especially in California. You say that your husband left everything to you so I am going to assume that an A-B Trust was not involved. That means that when you pass, everything in your own half of the estate plus what your husband left you (his half) will be subject to the death tax. Plus, assuming that the income from the $4 million estate allows you to not dip into principal for living expenses, it will probably be more than it is worth today due to inflation and appreciation. You might be worth well more than whatever the exemption is at that point in time. If that is the case then anything over the exemption amount will be subject to the death tax, currently at a rate of 40%.

Let’s take an example. For simplicity, we will ignore the exemption inflation factor and just assume it is a flat $5 million. If your estate appreciates to $6 million at the time of your death then the death tax taken from your children’s inheritance will be $400,000 ($6 million estate minus $5 million exemption times 40%). If it appreciates to $7 million then the tax will be $800,000.

Marital Deduction: But here’s the kicker. Where a decedent leaves anything directly to the surviving spouse, a deduction for death tax purposes is allowed for the value of what is left to the spouse. In your case all $2 million of your husband’s assets were left to you. So here’s the death tax calculation: gross estate of $2 million minus the deduction (technically called the marital deduction) of $2 million leaves a taxable estate of $0. No estate tax exemption needs to be used to reduce the tax since there is no tax in the first place.

Deceased Spouse Unused Exemption: That little tidbit is important. Here’s why. You can transfer over (or port) your husband’s unused death tax exemption to yourself, i.e. it’s portable. This is called the Deceased Spouse Unused Exemption (DSUE). So instead of his unused exemption evaporating, it can be used when you die. Essentially you now have a $10 million exemption. His unused $5 million (or whatever the inflation factor increased the exemption to when he died) and your $5 million. The inflation factor continues to apply to your $5 million. Depending on the value of your estate when you die that extra $5 million that you received from your husband can be worth $2 million ($5 million times 40%) to your children.

Capital Gains: Another reason it may be important to file a death tax return. Assuming you do have an A-B Trust, the assets in the B Trust typically do not obtain a step up in basis for capital gains income tax purposes on your death. What are we talking about here? If you buy something for $10,000 and sell it for $100,000 you have a profit (the IRS calls it a capital gain) of $90,000 and potentially you pay income tax on that. Combined Federal and California tax might be 30-35%. That’s approximate $30,000 (90,000 times 33%) in taxes. But if you die before you sell it the asset obtains a new basis (or starting point) equal to the fair market value at the date of death. If it is worth $100,000 at that time, then its basis is $100,000. If your children then sell it for $100,000 their capital gain for tax purposes is 0 and they pay no capital gain tax. Another way of saying this is that the IRS forgives the predeath appreciation.

Qtip Election: All well and good, but how do we apply that principle to the assets in the B Trust. After the first spouse dies, a tax election can be taken to tell the IRS that you want the B trust to focus on income tax savings rather than death tax savings. After all, if there is enough death tax exemption available (especially with the DSUE) to cover the projected value of the entire estate when you die, then why worry about death tax? This is called the Qtip election. With this election in place, the assets in the B Trust are allowed to obtain a step up in basis on your death.

Projections: In order to make an intelligent decision, certain projections have to be made: your life expectancy and future appreciation certainly play into this. Obviously, if a surviving spouse has $1 million total, has little hope of any significant appreciation, does not play the California lottery, did not have an A-B Trust with her spouse, and has a short life expectancy, it would seem somewhat silly to file a death tax return for the deceased spouse.

Qualified Specialist: Taxes, both death and income (including capital gain) are issues that always need to be explored when one dies. And consulting with a competent attorney (see explanation of the California Specialist Certification program) is highly advisable.

11/2013