In order to accomplish tax planning which results in the lowest possible overall tax bill, four different types of tax must be considered. Each type of tax has very different, and sometimes conflicting rules, so the impact of each type of tax on the individual situation must be balanced before the overall tax effect can be determined.

The types of tax which must be considered before completing any estate plan are:

	State Inheritance and Estate Tax
	Federal Estate Tax
	State and Federal Gift Tax
	State and Federal Income Tax
	State Inheritance and Estate Tax

Estate tax is a tax on the estate itself, so the tax is based upon the total value of the estate. In many states no state estate tax is due on estates that are not subject to federal estate tax. However, some states do assess estate tax on smaller estates.

Inheritance tax is applied against the property received by each beneficiary or heir. Tax rates and exemptions usually depend upon the relationship between the decedent and the person receiving the property. Inheritances of spouses and children are typically subjected to fewer taxes than are inheritances of people who are distantly related or not related at all. Many states no longer have an inheritance tax, and several states which did have inheritance tax have repealed the tax. However, individual state law should be reviewed in order to calculate and plan around any potential state inheritance or estate tax.

Federal estate tax is federal tax upon the estate itself. Many estates are exempt from the tax. A transfer between spouses is always exempt; provided that no restrictions are placed on the interest inherited by the spouse, and provided that both spouses are U.S. citizens. The amount of property which may be transferred free of federal estate tax varies depending upon the year in which death occurs, with exclusions as follows:

It is easy to assume that tax planning is not necessary with these large exclusions. However, many people underestimate the value of their future estates. Almost all assets are includable in the taxable estate, and substantial appreciation will likely occur between now and the time that the taxable estate will be valued for tax purposes (either the date of death or six months thereafter). Federal estate tax has the highest tax rates remaining in the United States today. Additionally, the Economic Growth and Tax Relief Reconciliation Act of 2001 contains a sunset provision which causes the entire Act, including federal estate tax exclusions, to revert to the law prior to passage of the 2001 Act as of January 1, 2011 unless future legislation extends the 2001 Act. Therefore, if combined estates of both spouses (including life insurance owned by spouses and all other assets) may exceed $1 million by 2011, federal estate tax planning is important.

With appropriate planning, a husband and wife are able to transfer assets using TWO exclusions since each spouse is entitled to transfer their applicable exclusion amount free of tax. However, wills or joint tenancy designations often give all property of one spouse to the other spouse. If the total estate of the husband and wife exceeds the amount of one applicable exclusion amount, the effect of an estate plan of this type can be VERY costly. Some planning techniques may be utilized upon the first spouse's death, but methods are much more limited after death than if planning is completed during lifetime.

In order to receive the federal estate tax credits of both spouses, upon the first spouse's death an estate plan can provide that assets be transferred to a credit shelter trust which makes use of that spouse's credit. During the lifetime of the surviving spouse, all income of the credit shelter trust and access to trust principal may also be provided to the spouse as long as Internal Revenue Code requirements are followed. When neither spouse survives, the assets of the credit shelter trust are distributed according to the plan of distribution designated by the estate planning documents of the first spouse to die. Assets retained by the surviving spouse are tax exempt up to the applicable exclusion amount available to the surviving spouse. Using this relatively simple planning technique can save hundreds of thousands of dollars in federal estate tax!

One method of estate planning is to make lifetime gifts in order to lower the value of the future taxable estate. State and federal gift and income tax ramifications should be considered prior to making any gift. Gift taxes vary from state to state. Some states have no gift tax, others follow the same rules as federal gift tax, and other states have totally different gift tax regulations. Gift tax for the individual state should be checked at the time that gifting is contemplated.

On the federal level, as of January 1, 2006, a gift of up to $12,000 per person per year may be made with no gift tax due, and there is no limit on the number of people who can receive a gift from you. Your spouse may also make $12,000 gifts, so a couple can give up to $24,000 per year to any number of people. The annual exclusion increases periodically, based on inflation indexing. As of 2006, no gift tax is due unless gifts exceed $2 million plus the available annual gift tax exclusions per person per year. These gifts in excess of annual exclusions reduce the federal estate tax exclusion amount on up to the $2 million and create immediate gift tax on any additional gifts. Gift tax returns must be filed for gifts over the annual exclusion amount.

In making gifts, keep in mind that the person receiving the gift may forfeit some income tax benefits which are available only on inherited property. This is especially important if the basis (original cost plus improvements minus depreciation) in the property which you are considering gifting is very low. For example, John bought real estate in 1982 for $5,000, and it is now worth $105,000. If John gifts the property to his son, Sam, Sam's tax basis in the real estate is $5,000. If Sam sells the property for $105,000, he will have taxable income of $100,000. If Sam inherits the property upon John's death, if the date of death is prior to January 1, 2010, Sam receives a basis in the real estate which equals the fair market value of the property upon John's death. Therefore, Sam's basis would be $105,000 and if he sold the asset for $105,000, he would pay no income tax on the gain! If the property is used as rental property or is other depreciable property, after inheritance the asset may be re-depreciated using the increased basis.

As of January 1, 2010, this benefit will apply to forgive capital gain on up to $1.3 million of inherited assets, plus an additional $3 million of assets inherited by a surviving spouse. If significant amounts of appreciated assets exist, planning is essential to ensure that titling of assets will take advantage of all allowable forgiveness of capital gains tax. Prior to 2010, planning is also important to benefit from all potential capital gains tax planning options.

Tax planning can be incorporated into either a will or a living trust. However, although a will allows for tax-planning provisions, assets transferred by will must go through probate. If property is held in joint tenancy, probate is avoided but the tax planning in the will is also bypassed. With a living trust, tax planning can be achieved and probate is avoided.

As of January 1, 2010, this benefit will apply to forgive capital gain on up to $1.3 million of inherited assets, plus an additional $3 million of assets inherited by a surviving spouse. If significant amounts of appreciated assets exist, planning is essential to ensure that titling of assets will take advantage of all allowable forgiveness of capital gains tax. Prior to 2010, planning is also important to benefit from all potential capital gains tax planning options.

Tax planning can be incorporated into either a will or a living trust. However, although a will allows for tax-planning provisions, assets transferred by will must go through probate. If property is held in joint tenancy, probate is avoided but the tax planning in the will is also bypassed. With a living trust, tax planning can be achieved and probate is avoided.