Do not be fooled by the estate tax lapse of 2010. It is true that the estate tax - which imposed a 45% tax on all assets in excess of $3.5 million - was repealed for 2010 as part of the sweeping Bush tax cuts of 2001. But it is unlikely your estate will get a free pass.

For one thing, the repeal is only in place for one year. In 2011, the estate tax is slated to be reinstated with a higher rate of 55% and an exemption of only $1 million per estate. Also,

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even though the federal estate tax is (as of this writing) dormant for 2010, state-level estate taxes are still very much alive, and some kick in at levels well below $3.5 million.

It gets worse. In place of the estate tax in 2010, there's a capital gains income tax on an estate's appreciated assets, such as stock, real estate and homes, when they are sold. Under the 2009 estate law all assets got a "step-up" in basis when someone died, meaning they could be sold right away with no taxes due. But under the 2010 law, all gains in excess of $1.3 million on assets passed to non-spousal heirs (and an additional $3 million for certain gifts to a spouse) are now subject to the capital gains tax.

In acknowledgment of the obvious accounting nightmares this capital gains tax on inherited assets will create, it is widely believed the Obama administration will try to overturn the repeal this year, reinstating the estate tax retroactively to its 2009 levels as well as the step-up in basis. That means even if you die this month, when there is technically no federal estate tax in effect, the government may still say your estate owes taxes.

Regardless, if you are reading this the odds are very good you will not die this year and that there will be a traditional estate tax on the books when you do die. Fortunately there are proven ways to avoid taxes altogether through some careful estate planning. (For background reading, see 6 Estate Planning Must-Haves.)

Set Up a Credit Shelter Trust
The first step to incorporating a solid tax strategy into the estate planning process is to understand one simple concept: Taxes are only applied to the assets the decedent owned, not to assets he or she might have controlled in a properly drafted trust. It sounds like a rhetorical technicality, but the difference between ownership and control can mean the difference between heirs paying no taxes vs. forking over roughly half of an estate to the IRS.

Couples can take advantage of this nuance by setting up estate plans that divide assets into two separate trusts - a surviving spouse' trust and a family/credit shelter trust. When the first spouse dies the assets held in his or her family/credit shelter trust continue to benefit the surviving spouse, but they are not technically owned by the survivor. The idea is to make full use of the estate tax exemption of the first spouse to die, without compromising the living standard of the surviving spouse.

When the surviving spouse later dies the assets of both trusts are passed on to children or other heirs. But what was contained in the family/credit shelter trust isn't taxed as part of the second spouse's estate. Hypothetically, if the survivor's trust and the family/credit shelter trust each contained $1 million and the threshold for an estate tax was $1 million, the parents could pass the entire $2 million on to their heirs without triggering the tax. If we return to a $3.5 million exemption, each couple can pass on $7 million to their children free of federal estate tax. (For more insight, see Get A Step Up With Credit Shelter Trusts.)

Use an Irrevocable Trust
Another tax planning approach that allows families with assets in excess of the estate tax thresholds to control large amounts of assets without technically owning them is to set up irrevocable trusts for their beneficiaries. These trusts allow families to take advantage of the tax-free gift provision in the federal tax code, which states that any person can give gifts of up to $13,000 a year to anyone else. (Each spouse can give $13,000 to the same person, meaning $26,000 a year can go to each child or grandchild.)

Many older couples aren't ready to give up control of that wealth yet. But there is a solution: These gifts can be placed in trust for beneficiaries, while still being controlled by the donor's spouse. By setting up his and hers irrevocable trusts for their children, for example, parents can shelter $26,000 per child per year from any future estate taxes while serving as their own trustees to maintain complete control over the money while they are living. This amount can be leveraged further by purchasing life insurance using the funds gifted to the irrevocable trust.

Set up a Family Limited Partnership
For larger estates, which often include a family business or commercial real estate, proper planning requires a succession strategy for the management of the businesses or property. One effective way to implement a succession plan that secures the continuity of the business while also providing healthy estate tax advantages is to set up a family limited partnership.

This legal construct enables a business or property owner to make very detailed provisions for the management of those assets after his or her death. Some of these will be operational, such as setting an organizational hierarchy or directing the allocation of profits. Others will be designed to minimize tax exposure by "devaluing" the estate from a tax perspective. For example, by setting specific ownership limitations, such as land-use restrictions or divided ownership structures, it is possible to limit the owner's ability to sell or transfer the property. These restrictions can decrease the appraised taxable value of the property in the family limited partnership when it passes to heirs, allowing them to save on estate taxes.

Eliminate Taxes First, Then Mitigate
Beyond these steps there are a number of approaches wealthy families can take to mitigate estate-related taxes. For example, taxable cash gifts (those in excess of $13,000 per beneficiary per year) are taxed at a federal rate of 35% in 2010, which is much less than the 55% slated for the estate tax in 2011.

For the vast majority of wealthy Americans, though, estate taxes can be avoided altogether with an estate plan that is designed to protect assets from the long arm of the IRS.

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