Estate taxes can substantially diminish the worth of an estate intended for heirs in Texas. However, with proper estate planning, it is possible to avoid or minimize estate taxes using trusts and other strategies. This allows you to transfer more of your wealth to your beneficiaries estate tax-free.
This guide covers everything you need to know about estate taxes in Texas and how to avoid them through strategic estate planning.
Overview of Federal and Texas Estate Taxes
The federal government imposes an estate tax on estates valued above a certain threshold. For 2023, this federal estate tax exemption amount is $12.92 million per individual. Estates under this amount are exempt from the federal estate tax. The estate tax rate varies between 18% and 40% for assets exceeding the exemption threshold.
In addition to federal estate taxes, some states like Texas, impose their own estate or inheritance taxes. However, Texas does not have a state estate or inheritance tax. This makes estate tax planning simpler for Texas residents than for states that impose state and federal estate taxes.
What Estate Planning Strategies Can Reduce Estate Taxes in Texas?
If your estate may be subject to federal estate taxes, the following strategies can help minimize your tax liability:
Gifting Assets During Your Lifetime
One of the simplest ways to reduce your taxable estate is to gift assets to your heirs while you’re still alive. The federal annual gift tax exclusion allows you to give up to $16,000 per recipient in 2022 without the gifts counting against your lifetime estate and gift tax exemption.
Gifting assets like real estate or shares of a business over time allows you to reduce your estate without incurring gift taxes. However, you need to live at least three years after making the gift for the full value to be removed from your estate.
Establishing an Irrevocable Trust
An irrevocable trust enables you to place assets beyond your taxable estate’s reach while maintaining control over their fate. As the name implies, an irrevocable trust cannot be altered or revoked once set up. A properly structured irrevocable trust removes assets from your estate and provides estate tax savings.
A common option is an irrevocable life insurance trust (ILIT), which owns a life insurance policy on your life outside of your taxable estate. The ILIT beneficiaries receive the policy proceeds income and estate tax-free upon your death.
Making Use of Tax Exemptions and Deductions
Married couples can double up on estate tax exemptions and effectively shield over $24 million from federal estate taxes in 2022. Lifetime gifts between spouses are also unlimited if structured properly. When one spouse dies, the exemption amount they didn’t use passes to the surviving spouse.
Charitable donations and bequests allow you to deduct their value from your taxable estate. With proper planning, you can maximize deductions and exemptions to reduce estate taxes.
Setting Up a Family Limited Partnership
A family limited partnership (FLP) allows you to retain control of assets while reducing their value for estate tax purposes. You gift limited partnership interests to family members, who have limited rights. The restricted shares are valued lower than the assets themselves.
Over time, appreciation of the FLP interests stays out of your estate. Just be sure to retain enough limited partnership interests to avoid gift taxes.
Making Tax-Free Gifts
Making gifts during your lifetime is an effective way to reduce the size of your taxable estate. The federal gift tax exemption allows you to give away up to $16,000 per year per recipient without incurring any gift taxes. Married couples can gift up to $32,000 tax-free. Larger gifts may be subject to gift tax, but even those gifts remove assets from your future taxable estate.
Using Trusts to Avoid Estate Taxes
Different types of trusts allow you to transfer assets out of your estate and potentially avoid estate taxes. Here are some of the most common trusts used for estate tax planning in Texas:
Revocable Living Trusts
A revocable living trust allows you to place assets in a trust while still retaining control. You can act as the trustee and beneficiary during your lifetime. At your death, the assets pass to the trust beneficiaries estate tax-free up to the estate tax exemption amount. The assets also avoid probate. However, revocable trusts do not provide asset protection.
Irrevocable trusts allow you to permanently transfer assets out of your estate. Popular irrevocable trusts used for estate tax planning include:
- Irrevocable life insurance trusts (ILITs) hold life insurance policies outside your estate. This prevents life insurance proceeds from increasing your estate value. To avoid gift taxes, you make contributions to the ILIT to pay policy premiums rather than directly transferring ownership of the policy.
- Grantor-retained annuity trusts (GRATs) allow you to transfer asset appreciation out of your estate at a discount. You retain an annuity interest for a set term, after which the remaining assets pass gift tax-free.
- Intentionally defective grantor trusts (IDGTs) are designed so you remain the owner for income tax purposes. This allows you to sell assets to the trust without recognizing capital gains. The assets are removed from your estate and you can appreciate the estate tax-free.
Using Trusts to Avoid Estate Taxes in Texas
Texas has no state estate or inheritance taxes. Therefore, irrevocable trusts allow Texas residents to avoid only federal estate taxes. Some planning considerations for trusts in Texas include:
- Generation-skipping transfer tax – Transfers to grandchildren or lower generations may incur this additional 40% federal tax. Careful trust drafting is required to avoid it.
- Gift tax – Funding irrevocable trusts requires gifting assets. Staying within the federal gift tax exemption allows these transfers to be estate and gift tax-free. For 2023, the lifetime gift tax exemption is $12.92 million.
- Income tax – Texas has no state income tax. This can provide income tax savings on growth within irrevocable trusts.
Trust Strategies to Reduce Estate Size in Texas
Specific types of irrevocable trusts can help minimize or avoid federal estate taxes for Texas residents:
Grantor Retained Annuity Trusts (GRATs)
With a GRAT, you transfer assets to an irrevocable trust but retain a fixed annuity payment for a set term. After the term ends, any remaining trust assets pass to beneficiaries estate tax-free. The value of the taxable gift when funding a GRAT is discounted because of the retained annuity interest. GRATs work best with assets expected to appreciate significantly.
Intentionally Defective Grantor Trusts (IDGTs)
IDGTs allow you to remove assets from your estate while still paying income taxes on trust assets. This structure allows you to do further estate tax planning, such as selling assets to the trust without incurring capital gains taxes. Appreciation in the IDGT assets accrues outside of your estate. Careful drafting is required to make the IDGT defective for estate and gift tax purposes but still a grantor trust for income tax purposes.
Charitable Remainder Trusts
These irrevocable trusts provide income to you and/or beneficiaries for a term of years or lifetimes, with the remaining trust assets passing to charity at the end of the term. This qualified charitable deduction reduces your taxable estate. Texas has no estate tax, but the charitable deduction can still minimize federal estate taxes.
Qualified Personal Residence Trusts (QPRTs)
Transferring your home into a QPRT removes it from your taxable estate. You retain the right to live in the home rent-free for a set term. After the term, the home passes to the trust beneficiaries estate tax-free. The value of the gift is discounted based on your retained interest. QPRTs work best when you expect rapid home appreciation after the trust term.
- Texas does not have a state estate tax or inheritance tax. Federal estate taxes still apply.
- Estates under $12.06 million are exempt from federal estate tax in 2022. Proper planning is key for larger estates.
- Lifetime gifting of assets can reduce estate taxes. Annual exclusions let you gift $16,000 per recipient tax-free.
- Irrevocable trusts, FLPs, deductions, and other strategies can minimize your estate tax liability.
- Work with an experienced estate planning lawyer to navigate estate taxes in Texas. Proper planning can save your beneficiaries hundreds of thousands in taxes.
The bottom line is that with the right planning, it is possible to avoid or significantly reduce estate taxes in Texas. An estate planning attorney can help craft a customized strategy based on your specific situation. Taking action early maximizes the options available to minimize taxes and retain more of your hard-earned wealth for your loved ones.