Meeting the "Big Three" Federal Estate-Related Taxes

The Bermuda Triangle, as you recall, is that stretch of ocean where ships and airplanes have disappeared without a trace. The federal tax system has its own Bermuda Triangle — a trio of taxes that work together to make as much of your estate as possible disappear without a trace: the estate (death) tax, the gift tax, and the generation skipping transfer tax (or GSTT) .

Navigating through federal estate taxes
The folks who wrote the laws and rules for the federal estate, gift, and GSTT taxes created some confusing relationships among the three taxes. You absolutely, positively want to use the experts on your estate-planning team — particularly your accountant and your attorney — to help you make sense of the odd relationships among these taxes.


The gift tax
The federal gift tax is imposed on taxable gifts that you give to others. The premise behind the gift tax is fairly straightforward. If you try to avoid estate taxes by giving away a significant portion of your estate while you're still alive, the government applies a tax on those gifts — sort of a "pay me now because you're not going to be paying me later!" approach.

The sort-of-good news is that you have a variety of exemptions and allowances to work with in your gift giving to help you minimize the actual tax bite or even escape the tax bite completely in some cases. Also, even if you make taxable gifts, you may not ever have to actually pay gift taxes (that is, to actually write a check for the amount you owe) because you can credit the amount of gift tax you owe against any down-the-road estate tax after you die.

The generation skipping transfer tax, or GSTT
The GSTT closes a loophole that the upper class has used to reduce estate taxes. For many years, wealthy people directly transferred some of their property to members of lower generations — to grandchildren rather than children.

The idea was that if a wealthy grandfather left lots of money to his own children who were wealthy in their own right, then they'd never need to spend that money — and most of what the grandfather gave as gifts or left in his will was taxed. Then, when the grandfather's children died, that same money that they didn't need to spend or otherwise get rid of once again was taxed when it was passed to their own children. So the grandfather thought ahead and just gave or left the money directly to the grandchildren or set up certain types of trusts, and essentially the money was taxed (for estate purposes, not for income purposes) only once instead of twice because the grandfather had skipped over an entire generation within his family.

Think of the GSTT as "closing the generation skipping loophole" (at least, GSTT proponents position and explain the tax that way) by adding an additional tax — and at pretty hefty rates — to property transfers that can be classified as generation skipping to make up for the amount of tax that you're trying not to pay.

The good news, though, is that you have a sizable exemption amount to work with, and you can work with your attorney and accountant to minimize the GSTT bite.

The estate (death) tax
The federal estate tax is scheduled to go away in 2010, but you — and everyone else — still need to worry about the federal estate tax, no matter how big (or small) your estate is. The death of the estate tax may only be for a single year. Unless Congress explicitly acts to extend the federal estate tax repeal (meaning that 2010 has no estate tax), the estate tax comes back in 2011.

Deciphering state inheritance and estate taxes
Depending on where you live, your state inheritance and estate tax situation will be one of these four scenarios:

No estate-related taxes at all — lucky you!
A state estate tax, which operates much the same way as the federal estate tax does. A tax is imposed on your estate's value and is paid out of your estate (typically by your personal representative).
A state inheritance tax, which actually taxes your beneficiaries on what they receive, rather than the estate itself. Don't forget that the primary responsibility for filing the inheritance tax return and paying the tax usually falls on the personal representative.
A pick-up or soak-up tax, which is a sort of tax: Your estate doesn't actually owe any additional money to pay that tax, even though a state estate tax return likely needs to be filed. The state gets a cut of what would otherwise be paid to the IRS (but your personal representative still probably has to file a lot of state tax paperwork anyway).
Keep in mind several points about state death taxes. First, some states are repealing or phasing out their inheritance or estate taxes, but don't be surprised to see other states that currently don't have estate-related taxes instituting either an inheritance or estate tax. Whereas most state governments had budget surpluses throughout the 1990s, the early 2000s have been quite a different story with deficits coming back as a result of economic slowdown. As a result, states are looking to all kinds of new or increased sources of revenue to help cover shortfalls.