FEDERAL ESTATE TAX: THE GROSS ESTATE

 

 

Some men see things as they are and say "why?”  I dream things that never were, and say, "why not?”

George Bernard Shaw.

 

 

INTRODUCTION

 

The contents of the gross estate will vary in the number and amount of annuities, joint property, powers of appointment or life insurance.  Basically the gross estate will include all items owned or controlled by the deceased at the time of death.  Of course the amount included will always depend upon the value and the percentage of ownership the deceased had in the property.

 

ESTATE TAXES

 

(Note:  Please see the SUPPLEMENT at the end of this text for up-date)

The purpose of Federal Estate and Gift Taxes is to prevent the transmission of large estate without being taxed.  It is often said that this tax is a legacy of the late 19th century when John Rockefeller and Andrew Carnegie created huge estates that Congress felt should be taxed.  Now the estate tax reaches estates of middle and even lower-middle income class.  Unfortunately, the larger estates usually have property estate planning, so it is the middle and lower-middle income classes which are the hardest hit by this tax.

 

The tax starts at a rate of 37% and increases to 55%, as discussed in more detail later.  Each person receives a tax credit of $211,300 so people generally avoid paying any of these taxes until their estates exceed $650,000 (1999).  In today’s environment where homes are worth $200,000+, many people have $500,000 or more in life insurance, and family farms are worth over $1,000,000, most people must at least consider the effect of estate taxes. 

 

As discussed later, estate taxes become due at a time when the cash necessary to pay the taxes may not be available (note discussion of life insurance for this purpose).  In the absence of estate planning , it is not uncommon for a family business to be forced to liquidate in order to pay the estate taxes.  Even a $900,000 family (mom and pop) business may require a $200,000 payment to the Federal Government.  Further, in Pennsylvania, for instance, state inheritance taxes could add another $50,000.

The common strategies to dealing with estate taxes, and which are discussed in detail later, are (1)  making gifts to heirs during one’s life, (2) making charitable contributions or establish a charitable trust, (3) create an irrevocable trust during one’s life, and (4) making maximum use of both the individual’s and the spouse’s tax credit.

 

One should keep in mind that estate tax is not an inheritance tax.  An estate tax is levied on the whole estate and before the assets are distributed to the heirs.  An inheritance tax is paid by the heir or the beneficiary on their share of the estate that he or she receives.  Inheritance tax vary from state to state, which will be discussed in detail later in this text.

 

“Gross Estate” will be discussed in more detail later, but as a general rule, a Gross Estate for tax purposes is all the property owned by the individual, or over which he/she has a controlling interest.  Another general rule is that property is included in the gross estate at its fair market value at the time of death.

THE GROSS ESTATE

 

The Internal Revenue Code devotes ten sections to include property in an estate.  Some general observations are in order prior to discussing the various categories.

 

OBSERVATION I: 

The gross estate includes the fair market value of all assets owned by the decedent as of the  date of death, including life insurance policies.

 

OBSERVATION II: 

Transfers between spouses generally qualify for the unlimited marital deduction and are free of current tax, (I.R.S. Section. 2056).

 

OBSERVATION III: 

If the value of the estate assets decline during the first six months after death (which often happens if the decedent owned a business) the value as of six months after death may be used on the tax return.

 

OBSERVATION IV:

  Lifetime gifts which exceed the annual exclusion ($ 10,000 per donee per year) will also reduce the estate owner's unified credit.


 

OBSERVATION V: 

Some transfers made during one's lifetime may be brought back into the decedent's estate.  Four examples would be:

 

  1. Transfer of life insurance policies with three years prior to death.  (I.R.S. Sec. 2035).

 

  1. Transfer of an asset from which the donor retains an income for his/her life (I.R.S. Sec 2036).

 

  1. Transfer of an asset where donor retains the right to alter  or terminate the transfer.  (I.R.S.. Sec. 2038).

 

  1. Assets placed in joint tenancy with another are included in the gross estate.  The federal estate tax, paid by the estate, is a tax on the right to transfer property when a person dies.  The gross estate is the total value of the person's property at the time of death.  The estate tax is paid by the estate and not by the individuals receiving the property.  Constitutionally, the federal estate tax is not a tax on the property but is a tax on the privilege of transmitting property.  In reality, the federal estate tax is a tax on the transfer or relationships (ownership) to the property at death.  Also same states levy an inheritance tax, which is a tax on the right to receive property.  An inheritance tax is paid by the individuals who receive the property that was transferred by the decedent.

 

STATE INHERITANCE TAXES AND REAL ESTATE  (Supp.)

 

State Inheritance taxes are always a consideration in Estate Planning, and real estate investors can have the biggest problem with those particular taxes.  The Federal Estate Tax doesn’t raise much revenue as it is designed to limit the ability of person to pass wealth on to subsequent generations.  But state inheritance taxes are used to bringing considerable revenue to the states and state inheritance taxes can be quite high. 

 

It should be noted that the state in which the property is located is the one that imposes the inheritance tax.  Even if one moves to a tax-free state, such as Florida, if property is owned in another state – such as New York – the property in New York will be hit with a high inheritance tax.

 

One solution is to incorporate the property or put it into a partnership.  That way, the property owner is not an "owner” of property, but an owner of stock.  Personal assets such as this stock, would be taxed in the state of residence at time of death.  Since inheritance taxes vary from state to state, an attorney should always be consulted to make sure that this will work in the state in which the property is located.

 

HOW THE I.R.S. CODE AFFECTS THE GROSS ESTATE

 

GROSS ESTATE:  AN OVERVIEW

 

I.R.S. SECTION        DESCRIPTION OF PROPERTY INTEREST

 

 1.    2033    Most property owned outright by decedent.

 

 2.    2034    Dower and courtesy interests.

 

 3.    2035    Transfers of property within three years of death.

 

 4.    2036    Transfers of property with a retained life interest.

 

 5.    2037    Transfers with a retained reversionary interest.

 

 6.    2038    Transfers with a retained power to revoke.

 

 7.    2039    Annuities.

 

 8.    2040    Joint property.

 

 9.    2040    Powers of appointment.

 

10.   2042    Life insurance.

 

 

1.  SECTION 2033

 

I.R.S. Section 2033 refers to the value of any property interests at the time of death to the extend of that interest.

 

  1. General inclusion rule:  Generally means that the gross estate includes the value of all property interests, real or person, tangible or intangible, of an individual on the date of death to the extend of the individual's interest in the property.  Remember that property rights are determined by state law and federal law dictates whether those rights are taxed.
  2. Types of includible property interests must be those that are beneficial.  A mere legal title does not mean the property is includible.

 

  1. Limitations of Section 2033:  interests in which the decedent possessed no right to pass the property at death are not includible.

 

CONSUMER APPLICATION

If the decedent is one of five owners (20%)  tenant-in-common of a piece of land, only the 20% is included in the gross estate.  Also, if the decedent only had a life estate  in the property (right to enjoy the property for life, but not to leave the property to others), then only the value of this life estate is included in the gross estate.

 

D.    Three factors to determine inclusion:

 

1.        Types of property includible under  State or Federal Law.

 

2.        If decedents’ interest was large enough to warrant inclusion.

 

3.      Whether decedents possessed interest at time of death and to what extent.

 

FOURTEEN ITEMS OF INCLUSION

 

A listing of all of the property that would be included in the gross estate illustrates why this section can be called the "catch-all" section.

 

1.     Any interest in real estate.

 

2.     Cash, money equivalents.

 

3.     Stocks, bonds, notes, mortgages, outstanding loans to others.

 

4.     Income tax refunds not yet paid.

 

5.     Patent, copyrights.

 

6.     Property subject to indebtedness.

 

7.     Amounts to which decedent was entitled before death such as legitimate claims for damages for pain and suffering.

8.     Medical insurance reimbursement due to a decedent.

 

9.     Dividends declared and payable before death but not yet received.

 

10.   Income in respect of a decedent, all rights to income accrued as of the date of death (renewals!).

 

11. Miscellaneous property such as partnership or corporate interests.

 

12.   Tangible personal property (furniture, jewelry) but not property belonging to a spouse.

 

13. Vested rights to property in the future.

 

CONSUMER APPLICATION

Alex creates a trust under which his mother, Sally, is to have the income off the trust for life.  At the death of Sally, the trust will revert to Alex.  (Reversionary Trust).  A’s interest in the trust would be computed actuarially  (i.e., Alex’s interest prior to Sally’s death, would be based upon the life expectancy of Sally).

 

  1. Value of decedents share of property held in conjunction with others (property held as a tenant is common).

 

2.  SECTION 2033A  (Supp.)

 

The Taxpayer Relief Act of 1997 (TRA 97) attempts to assist owners of family-owned businesses in the estate tax area.  This Section authorizes an estate to exclude a qualified family-owned business interest from the decedent’s gross estate, to the extent that the exclusion plus the unified credit does not exceed $1,300,000.  The maximum amount excludable under Section 2033A for a person that dies in 1999 will be $650,000 ($1,300,000 minus the 1999 unified credit amount of $650,000).

 

It has been reported that an unanticipated problem under this Section arises, because of the lack of coordination between the new family-owned business exclusion and the increase in the unified credit.  The unified credit under TRA 97, increases by specified amounts as stated earlier in this text.  Over a 9-year period, the amounts range from $625,000 in 1998, to $1,000,000 in 2006 and thereafter.  For instance, in 1998, the family business interest excludable in 1998 would have been $675,000 ($1,300,000 minus the $625,000 exclusion) and so the maximum excludable amount in 2006 would be only $300,000 ($1,300,000 minus $1,000,000).  To correct this problem, the Tax Technical Corrections Bill of 1997 coordinates the increase in the unified credit with the decrease in the family owned business exclusion so that there will be neither an increase nor a decrease in the total estate tax on estate holding qualified family-owned businesses as increased in the unified credit are phased in.  By the time that this text is published, this problem may have been totally corrected, but it is discussed here in case the question ever arises.

 

There are very strict eligibility requirements for the use of the exclusions under this Section 2033A.  The major requirements are:

 

  1. The business interest must exceed 50% of the decedent’s adjusted gross estate.
  2. The business must pass complex “material participation” tests which requires that the business must have been operated by the decedent or members of the family during five of the preceding eight years.
  3. “Qualified heirs” which includes certain employees, must have acquired the business.
  4. Qualified heirs must agree to pay an additional estate tax if within ten years after the decedent’s death, certain disqualifying events occur, such as the sales of the business to “outsiders”, i.e. not family members or certain employees.
  5. The Estate must elect the exclusion, i.e. the exclusion is not automatic.

 

While these exclusions may be detailed and considered as “strict”, the fact remains that if the business can be passed on to family members or to long-time employees, a very substantial tax savings has been provided.

 

In any event, this is a complicated legal provision of TRA 97, and most certainly should be reviewed by an attorney in those cases of family farms or family-owned businesses passing to family members or to long-time employees.

 

 

3.    SECTION 2034

 

DOWER OR COURTESY INTERESTS.  SEC. 2034

Dower rights is property set aside for a widow under state law if decedents’ interest in the property has been established.  These are rights provided for females.

 

Courtesy rights are widowers’ rights in a deceased wife's property.

 

Both rights are an inalienable right that a wife and husband have to a share of the deceased spouse's property.  These rights have been abolished in half of the states.

 

 

4.  SECTION 2035

 

Certain gifts and transfers made and gift taxes paid within three years of death.  Sec. 2035.  This rule has undergone changes throughout the years as Congress grappled with what was fair and equitable.  The 1976 Tax Reform Act ruled that the value of all transfers made within three years of death are includible in the gross.  Then in 1978 the Revenue Act automatically excluded gifts made within three years of death for which no gift tax is required (Gift tax returns are not required for present-interest gifts of $10,000 or less, unless gift-splitting is used).  Finally in 1981 the Economic Recovery Tax Act stated that gifts made within three years of death are not included in the gross estate for decedents dying after December 31, 1981.  There are five exceptions:

 

Exception 1:  Transfers with retained interest for life.  This could include transfers in which the decedent reserved the right to:

 

1.     Receive or determine who receives income from the property unless given up more than three years before death.

 

2.     Designate who is entitled to possession or enjoyment of the property either for life or for a period that did not actually end before death or that cannot be determined without reference to the death unless the property was given up more than three years before death.

 

Lifetime transfers which are included in the gross estate would be:

 

1.    Use, possession or other enjoyment of the transferred property for the decedent.

 

2.    Right to name other persons who may possess or enjoy the transferred property or income for the property.

 

Exception 2. Transfers taking effect upon death.  These transfers are included in the gross estate:

 

A.   Transfers to other that can be obtained only by surviving the decedents and if the decedent retained a reversionary interest in the property's value at death.

 

B.    These transfers are includible if the decedent exercised the power or transferred the power within three years prior to death.

 

C.   If the decedent retained the power, the property is includible under Section 2037.

 

Exception 3.  Transfer in which decedent reserved the right to alter, amend, revoke or terminate the transfer or the power to affect the beneficial interest in the transferred property.  If the decedent disposed of these rights within three years before death, the property's value is includible under Section 2035.

 

Exception 4.  Transfers by the insured of life insurance policies.  Gifts of life insurance within three years of death are includible in the gross estate at full value of the proceeds whether or not a gift tax return was required.

 

 

Note:  However, premiums paid or deemed paid within three years of death to the extent that the payments would not have caused policy proceeds to be included in the gross estate under prior law, are not included.

 

Exception 5.  Gift Taxes Paid.  Gift taxes on gifts within three years of death made by the decedent or the decedent's spouse are includible in the gross estate.

 

Exceptions To The Three Year Rule

 

1.   Gifts worth less than the amount of the annual exclusion ($ 10,000) because no gift tax return is required.

 

2.   The value of all property effectively transferred within three years of death is included only for determining qualification for:

 

A. Section 6166 Estate Tax Deferral.

 

B. Stock redemption to pay administration, and funeral expenses and Estate Taxes under Section 303.

 

C. Estate Tax liens.


 

5.  BASIS FOR TRANSFERRED PROPERTY INCLUDIBLE

 

Because of the three-year rule:

 

  1. Section 2035 property receives the date of death value for Federal Estate purposes with a stepped-up basis (property kept until death).

 

  1. Property given away during lifetime but more than three years before death retains the donor's basis plus gift tax attributable to pre-transfer appreciation.

 

CONSUMER APPLICATION

In 1979 Don purchased real estate for $2,000,000 and immediately gave the land to his daughter.  Don died four years later when the real estate was valued at $2,500,000.  If Don held the property, his daughter's basis would be $ 2,500,000 because of the step-up rule.  But the daughter's basis will be $ 2,000,000 (same as Don's basis) since Don gave the property to his daughter.  The daughter must pay capital gain taxes upon the sale of the property.

 

 

REVALUATION OF GIFTS FOR ESTATE TAX PURPOSES

 

The Tax Relief Act of 1997 (TRA 97) addressed the three-year statute of limitations for Gift Taxes in the following manner:

 

After a gift tax return has been filed and the three-year statute of limitations has expired without the I.R.S. challenging it, a taxpayer would normally assume that the value of the gift could not be altered by the I.R.S. later.  However, because of the unification procedure of gift and estate taxes, courts have allowed for a predetermination of a gift subsequent to expiration of the statute of limitations in order to permit determination of the appropriate tax rate bracket and unified credit for estate tax purposes. 

 

In other words, once a person had filed a gift tax return and there had been no challenge by the I.R.S. for a period of 3 years, the taxpayer thought that the I.R.S. could not go back and re-evaluate the gift.  But because the estate tax and the gift tax both apply for the unified gift, some courts decided that for estate tax purposes the I.R.S. could re-evaluate the gift.


 

TRA 97 now provides that a gift cannot be revalued for purposes of estate taxation after the statute of limitations has expired, provided that the value of the gift had been disclosed in a manner adequate to apprise the I.R.S. of the nature of the gift.  Further, the Tax Technical Corrections Bill  which was passed following TRA 97 for the purpose of defining some of the provisions of TRA 97, states that the value of a prior gift is the value of such gift as finally determined, even if no gift tax was assessed or paid on the gift.

6.      SECTION 2036

 

Transfer with retention of a life interest.  The gross estate will include all property transferred gratuitously by the decedent during the decedent's lifetime in which the decedent retained or reserved either the right to use, posses or enjoy the property or to receive the property income or the right to designate, (either alone or with someone else) the persons who should possess or enjoy the property or the property's income.

 

These rights must be retained or reserved in situations as illustrated in the following Consumer Applications:

 

CONSUMER APPLICATION

Hal makes a gift of an original Hawthorne Manuscript to Terry but reserves the right to keep the manuscript in his home for life.  The manuscript's value will be included in Hal's gross estate.

 

CONSUMER APPLICATION

Hal conveys his personal residence to Terry by deed but reserves the right to live in the house rent-free for life.  The value of the property at the time of death is includible in Hal's gross estate.

Note:  The Donor’s retention of a substantial economic benefit is all that is necessary for the including in the Donor’s gross estate

 

CONSUMER APPLICATION

Kay, a decedent, was the life income beneficiary of a Testamentary trust created by Kay's uncle.  Kay did not retain a life estate because she did not possess the original trust property, but she was allowed to transfer additional property to the trust.  Kay added $100,000 to the existing $ 400,000 principal during her lifetime.  At Kay's death, all trust property passed to her heirs.  If the trust was required to distribute all income currently and the trust's value at Kay’ death was $500,000, $100,000 is includible in Kay's gross estate.

Note:  Principal contributed by a decedent to a Testamentary trust created by someone else is considered a retained interest and is includible in the gross estate.

 

A decedent retains the right to income to the extent that the income is to be used to discharge the decedent's legal obligation (for example: Support of dependent children).

 

Reciprocal trusts which are created by a husband and wife for each other as life beneficiaries are included in the gross estates.  The property of each trust is includible in the life beneficiary's estate if the arrangement leaves both grantors in the same economic circumstances in which the grantors would have been had the grantors named themselves as life income beneficiaries.

 

1.    Transfers of stock of controlled corporation with the retention of voting rights are considered retention of the enjoyment of the property and the stock's value is includible in the gross estate.

 

2.     Decedent's retention or reservation of property for a period not determinable without preference to the decedent's death is includible in the gross estate.

 

CONSUMER APPLICATION

 John transferred property to a trust with the stipulation that he receives quarterly income installments.  Also there is a condition that no part of the income accruing during the quarter in which John dies is to be paid to John or to John's Estate.  The value of the trust property is includible in the gross estate.

 

3.     Any period that does not end before the decedent's death.  Keep in mind that the value of property includible under this section is reduced by the value of any interest income that is:

 

a.        Not subject to the decedent's interest and power.

 

b.        Actually being enjoyed by someone else at the time of death.

 

CONSUMER APPLICATION

 Jamie transferred 3,000 shares of IBM stock to his son but retained the right to receive dividends from one-third of the shares.  The value of 1,000 shares will be included in Jamie's gross estate upon death.

 

 

 

CONSUMER APPLICATION

Carl transferred a tract of law to his son, Adam, and reserved the right to the property income for five years.  Carl died after three years.  The entire value of the property is includible in Carl's Estate.

 

SUMMARY

“The value of all property over which the decedent retained the right to designate alone or with someone else who may enjoy or possess the property as well as the right to vary beneficial interests, is includible in the gross estate”.  This would include the situation when a decedent created an irrevocable trust, naming someone else as beneficiary but naming the decedent as trustee and the decedent had the power to accumulate or distribute income because the beneficiaries are denied the possession or enjoyment of the income.

 

Property held in an irrevocable trust will not be included in the grantor's gross estate if the grantor merely retained the right to appoint a successor trustee other than the grantor upon resignation of the original trustee.

 

If a grantor retains the ability to change corporate trustees without cause, the trust corpus is includible in the grantor’s gross estate.

 

Note:  The amount includible in the gross estate under Sec. 2036 is the value of the entire property transferred as of the date of death, not just the value of the interest retained or controlled.  

7.      SECTION 2037

 

Transfer that takes effect at death.  The gross estate includes the value of property transferred by the decedent for less than full and adequate consideration if the possession or enjoyment of the transferred property can be obtained only by the beneficiary surviving the death and if the decedent retained a reversionary interest worth more than 5% of the transferred property value immediately before death. 

 

A reversionary interest means the ability to have transferred property returned to the decedent.  The important aspects of reversionary interest are:

 

  • It would include the possibility that the transferred property either may return to the decedent or the estate or may be subject to the decedent's power of disposition.
  •  It does not apply to the reservation of a life estate or to the possibility of receiving income solely from the transferred property only after someone else's death.

 

  • It would not include the possibility that the decedent may receive an interest in the transferred property by inheriting the property through another's estate.

 

 

8.      SECTION 2038

 

Revocable transfer: The power to alter, amend, revoke or terminate or to affect beneficial enjoyment.  If any of these powers exist at death, the value of the property subject to the power is includible in the decedent's gross estate.

 

  • This is true whether the power is exercisable by the decedent alone or with someone else.

 

  • Types of powers covered under this section include the power to change beneficiaries, hasten the time that the beneficiary can receive the property and increase or decrease the amount of property allocated to any beneficiary.

 

Two exceptions to this rule are:

 

1.  If the decedent's power can only be exercised with the consent of all parties having an interest in the property.

 

2.  If the power added nothing to the parties rights under local law.

 

Other considerations of Section 2038 includes power to:

 

  • Revoke or terminate a trust to which property is transferred.

 

  • Control and manage trust property except as limited to mechanical or administrative duties only.

 

  • Change beneficiaries or vary amounts distributed.

 

  • Appoint by Will or change beneficiaries’ shares by Will.

 

  • Revoke.

 

  • Invade a trust created by another for whose benefit the decedent created a reciprocal trust.

 

Section 2038 does not cover powers that (1) is contingent on the happening of some event, (2) allows addition to the corpus, and (3) are created by others with funds not derived from the decedent and not supported by similar trusts created by others.

 

9.      SECTION 2039

 

Annuities.  Annuities are periodic payments over a set time.  The decedent's gross estate will include the present value of an annuity receivable by a beneficiary as a result of surviving the decedent.  An annuity is included in the gross estate when payable to the decedent:

 

1.     For life, then payable to beneficiary.

 

2.     For a period that did not end before death.

 

3.     For a period ascertainable only with reference to date of death.

 

If the annuity ends at the decedent's death, the annuity is not includible in the gross estate if payments to a beneficiary are not provided for afterward.

 

Key factor:  Whether or not the decedent had an enforceable right to receive payments from plan during lifetime.

 

Five annuities includible in gross estate:

 

  • Contracts under which the decedent received or was entitled to receive an annuity or other payment immediately before death and for the duration of life with stipulation that payments continue to beneficiary under decedents’ death.

 

  • Contract under which decedent received payments prior to death together with another person for joint lives with the stipulation that payments continue to survivor after death of any other individual (joint and survivor annuity).

 

  • Contract between decedent and employer under which decedent received or was entitled to receive annuity or other payment after retirement for life with payments to beneficiary upon death.

 

  • Contract between decedent and employer that provided for annuity or other payments to surviving beneficiary if decedent died prior to retirement or before expiration of a certain time.

 

  • Contract under which decedent was receiving or was entitled to receive an annuity or other payment for a specified time period immediately before death with payments to continue to named beneficiary if decedent died before time expiration.

 

Key Factor:  Basically, if the beneficiary receives any benefits under an annuity or annuity-like arrangement, these payments are included in the gross estate.

 

Amount includible.

 

  • Survivorship:  An annuity is included in the gross estate to the extent that decedent paid the purchase price.  If the decedent paid the total price, the whole survivorship interest (joint and survivor annuity) enters the estate.  If decedent paid 30% of the annuity and spouse (survivor) paid for 70% of the annuity, only 30% of the value of the survivor's income interest is included in the estate.

 

  • Excluded under Section 2039.  All amounts are paid as insurance on decedent’s life.  Life insurance proceeds are covered under I.R.S. Section 2042.

 

  • Non qualified retirement income.  If employee dies before retirement age, the death benefit is treated under general annuity rules which means it is included in gross estate.

 

     D.   Valuation of an annuity:

 

1.     Commercial annuity contracts (sold by company in the business of doing so): valued in comparison to similar contracts being sold by the company on the date of decedents’ death.

 

2.     Annuity benefits are valued as of date of death of a primary annuitant.  No alternate valuation date is possible because an annuity reduces in value by mere lapse of time.

 

3.     Lump sum payments are included in gross estate.


 

       4.  Payment in form of annuity may be excluded from gross estate if payable to someone other than Executor or estate (e.g., Keogh Plans, US Civil Service Retirement Plans).

 

       5.  Constructive receipt.  Annuities are included in the gross estate if the decedent had a right to have the plan proceeds distributed to decedent while alive.

 

ESTATE TAXATION OF ANNUITIES.

 

  • A life annuity with no certain period does not enter gross estate.

 

  • Life annuity with certain period.  If death is before end of period, present value of remaining payments enter gross estate.

 

  • Joint and survivorship life annuity enters estate of first to die in proportion to total premium paid.

 

10.    SECTION 2040

 

Jointly held property with right of survivorship between spouses.  Section 2040.  Where property is held jointly with right of survivorship between spouses the estate of the first spouse to die will include one-half of the value of the property regardless of which spouse furnished the money to purchase the property.

 

Three rules dictate this type of ownership:

 

  •  It is mandatory for jointly held property between spouses.
  • When the surviving spouse dies 100% of the property will be included in the surviving spouse's estate.
  • When an individual dies, only one half of the property was included in the gross estate, therefore, only that one-half will receive a stepped-up basis if the surviving spouse sells the property.

 

Creation of a joint interest in property between spouses is no longer considered a gift.  Present-interest gifts between spouses qualify for the unlimited gift tax marital deduction.


 

CONSUMER APPLICATION

In 1965, Bartle and Mabel, husband and wife, bought Whiterapids as joint tenants with a right of survivorship.  They paid $46,000 cash for the property consisting of 24 acres of unimproved real estate.  When Bartle died April 15, 1985, Whiterapids was valued at $500,000. 

1.     Assume that Bartle has furnished all of the $46,000 purchase price.  At his death, one-half the value of Whiterapids would be included in his gross estate.

2.     Assume that Mabel had furnished all of the $46,000 purchase price and that Bartle had died.  One-half of the value of Whiterapids would still be included in Bartle's estate.

3.     In 1988, Mabel dies.  The value of Whiterapids is now valued at $585,000.  100% of the value is included in Mabel's estate.

Bartle dies in April 1985.  One-half of the value of Whiterapids ($250,000) will be included in his gross estate regardless of how much money he furnished to by the property!  In 1986, Mabel sells Whiterapids for $550,000.  One-half of the amount included in Bartle's estate receives a stepped-up basis to $ 250,000.  The other one-half belonging to Mabel will be valued at the original cost basis of $ 23,000 (½ of  $46,000).  Total basis Mabel has would be:

 

Sales price = $550,000

Less basis

  23,000

250,000    =   (273,000)

Total gains    $277,000

 

The "consideration furnished rule" (better know as the Percentage-Of-Contribution Rule) requires inclusion of the full value of jointly owned property, except to the extent that the survivor can prove funds used to acquire the property.

 

The test is  that paid for the asset, not who owned the asset?  If one person gives funds to the other with less than the full and adequate consideration, the "gift" does not switch ownership.  This rule applies to all joint tenancies with right of survivorship other than those held between spouses.


Tracing the contributions of joint owners (other than between husband and wife):

 

1.     Contribution of the survivor must not be traceable back to the decedent.

 

CONSUMER APPLICATION

Joyce cannot receive a gift of $ 25,000 from her brother, invest the $ 25,000 in property with him and then claim that the contribution was hers.

 

2.     Contributions that come from income of gift property are not charged back to the donor.

 

Note:  If property was acquired by gift/bequest/inheritance by a non-spouse joint owner, only the value of the fractional interest of the first tenant to die enters the gross estate.

 

ADVANTAGES OF JOINT TENANCIES:

 

1.     Free from claims of creditors of the deceased owner.

 

2.     May save state inheritance taxes.

 

3.     Avoids Probate delays (and costs) and property passes directly to the survivor.

 

4.     Enhances family solidarity.

 

5.     Unlike a Will, a joint tenancy is not open for public scrutiny and cannot be "broken"

 

MAJOR DISADVANTAGES OF JOINT TENANCIES:

 

1.     Decedent can provide no restriction or management advice as can be done through a Will and trust.  (An alternative would involve keeping the property in sole ownership).  A Stepped-up basis is only available on one-half of the property.  This means that tax savings may not be worth as much as the potential capital gain tax and fully stepped-up basis.

 

2.   Establishing the value of the joint tenant's interest.  The rule dealing with valuation of jointly held property between spouses when the property was a closely-held business has been repealed by the automatic 50-50 division instituted by the Economic Recovery Tax Act.

 

Property held by Spouses as tenants by the entirety automatically enters the estate of the first spouse to die.

 

Jointly owned property to the extent included in the gross taxable estate that passes to the spouse will qualify for the marital deduction.

 

Under ERTA the maximum marital deduction has been increased to 100% of the property transferred from one spouse to the other, either by gift or at the first spouse's death.  An unlimited amount of property can be passed between spouses without any estate or gift tax.

 

11.    SECTION 2041

 

Powers of appointment.  General power of appointment means a power over property.  This power is so broad that the power approaches actual ownership or control of the property.  An estate owner may reserve a power by which one can appoint property to anyone without limitation including themselves or estate.  There are six elements of the power of appointment:

 

  • Creator (Donor):  The owner of property who directs that the property will be transferred subject to a power of appointment.  This is generally done in the Will, but can be done during life by including the power in his deed.

 

  • Recipient (Donee):  Takes the power given to donee by the donor.

 

  • Subject Matter (Property, either real or personal property):  Property over which the donee will exercise the power of appointment.

 

  • The power which is transferred:  This can be either a General Power or a Special (Limited) Power.

 

  • Objects of the Power:  The donee may appoint the property to any number of entities, other individuals, charities or corporations.

 

6.   Appointees of the Power:  The ultimate beneficiaries of the exercise of the power;  property is received by the appointees.


 

Key Points:

 

Property over which an individual has a General Power of Appointment is included in the estate for estate tax purposes whether the power is exercised or not and whether the person is competent to exercise the power or not.

 

1.  If the general power is exercised or completely released during life, a gift tax will be triggered.

 

CONSUMER APPLICATION

The decedent, who was a surviving spouse, had been given income from the property for life with the right to appoint or dispose of the property at death to the decedent's estate, creditors or beneficiaries by Will.  Although the decedent did not have the power to transfer the property during the decedent's lifetime, the value of the property subject to the power will be included in the decedent's estate.

 

2.  Property subject to power will not be includible in holders’ gross estate if consent is required from the donor, person having a substantial adverse interest to the donee or a person in whose favor power may be exercised.

 

CONSUMER APPLICATION

If the decedent was given the power to appoint the trust principal to any of three beneficiaries, not including the decedent, this would not be a general power of appointment.  But, if the decedent had the power to invade the corpus for decedent's own benefit without limitation, this would be a general power of appointment.

 

3.  If the donee of a power does not want the property included in donee's estate, the  donee must release or exercise the power during the donee's lifetime.  A release must occur more than three years prior to death or the property will still be included in the donee's gross estate.


 

QUALIFIED DISCLAIMER:

 

1.  Disclaimer:  If the decedent refused to accept power of a appointment; nothing is included in the disclaimer's estate.

 

2.  A Qualified disclaimer is not a taxable gift.

 

3.  To be qualified, a disclaimer must be received in writing by the transfor or the representative within nine months of transfer or by disclaiming prior to the disclaimer’s 21st birthday.  The person disclaiming must not direct to whom the power of appointment passes.

 

 

GENERAL POWER LIMITATIONS        

 

  • The decedent's power to invade is limited and is to be used only for reasons of health, education, support or maintenance.

 

  • The power can be used only with the consent of creator of power or person with adverse interest in the property (stands to gain).  Created after 10/21/42. 

 

  • If a power is created before October 21, 1942, exercisable only in conjunction  with another person, is not a general power.

 

  • When a person is given a power that can only be exercised in conjunction with others in whose favor the power could be exercised, a fractional portion of the property will be includible in the donee's estate.

 

A fractional portion is determined by dividing the value of the property by the number of persons in whose favor the power could be exercised.

 

CONSUMER APPLICATION

Manny grants Moe, Jack and Joe the unrestricted right to appoint property to either of the three (with the consent of the others) during each person's lifetime.  In default of the appointment, the property will go to Agnes.  At Moe's death, only one-third of the value of the property would be includible in his gross estate.

 

Time of creation:  A power created by Will is considered to be created on the date of the testator's death.  A power created by deed/other instrument during creators’ lifetime is created on the date the power becomes effective.

 

       5.  Special Power of Appointment:  Refers to any power that is not a General Power. The holder of power may exercise power only in favor of someone other than holder or in favor of a limited class of persons.

 

These may be freely retained and freely exercised without tax consequences. A fairly broad (e.g., retained, exercised, released, allowed to lapse) power may be given to another person without adverse tax consequences, but a power reserved by the grantor, even though limited, will likely result in tax problems.

 

POWER OF APPOINTMENT AS USED IN ESTATE PLANNING

 

1.   Flexibility.  the following powers may be given without tax consequences:

 

  • Beneficiary can withdraw $ 5,000 or 5% of the value of the corpus each year, whichever is greater.

 

  • Beneficiary can be given right to withdraw in excess of the five and five rule in order to maintain a standard of living or for medical expenses.

 

  • Trustee may be given power to distribute principal to beneficiary at own discretion.

 

  • Beneficiary can be given special power by deed to appoint corpus to a limited class (e.g., to spouse or to children).

 

2.  Estate Tax Savings:  Property left to wife as life tenant with remainder to son escapes estate tax at wife’s death;  property can be left to wife outright who can give son a life estate with remainder to grandchildren.

 

3.  General purpose of donor: can be specified and details left upon to donee.

 

12. SECTION 2042

 

Life Insurance.  Life insurance proceeds are included in the estate for tax purposes if:

 

  • Decedent had incidents of ownership in policy.  These incidents of ownership include the right to:

 

 

        A.       Name/change beneficiaries.

 

        B.       Assign the policy.

 

        C.       Revoke an assignment.

 

        D.       Surrender/cancel policy.

 

        E.       Pledge policy for a loan.

 

        F.       Take loan or surrender value of policy.

 

        G.       Change beneficiary on a policy owned by closely-held corporation.

 

        H.       Purchase policy originally purchased by employer.

 

        I.        Change ownership, benefits, proceeds in policy owned by a trust.

 

        J.        Deal with policy even after policy is physically transferred.

 

       K.       Control policy owner

 

        L.       Reversionary interest worth more than 5% of policy value.

 

GROUP LIFE INSURANCE

 

Included in the decedent's estate if decedent had the right to:

 

1.     Change beneficiaries.

 

2.     Terminate policy.

 

3.     Prevent cancellation of contract by purchasing policy.

 

Group Insurance is not included if:

 

1.     Power to terminate policy is limited to termination of employment.

 

2.   Right to convert group policy to individual policy at end of employment is assigned to another.

 

 

MARITAL DEDUCTION AND LIFE INSURANCE

 

Life insurance proceeds do not qualify for the marital deduction if the life insurance is payable to a surviving spouse but is not in decedents’ gross estate (no incidents of ownership). 

 

CONSUMER APPLICATION

Ralph is employed by Sandler Co. and participates in a pension plan that is entirely paid for by Sandler Co.  The pension plan has a death benefit that would pay $50,000 at his death, to his beneficiary, his wife.  If Ralph dies and his wife elects to receive the $50,000 in a lump sum, she would have to pay income tax on the proceeds.

 

Transfers of Life Insurance within three years of death are included in gross estate as gratuitous transfer.  Inclusions of gross income are quite extensive.  A detailed discussion of life insurance transfers would be voluminous, so salient points only are included in this text.

 

The federal estate tax (FET) is a tax on the right to transfer property when a person dies and is paid by the estate.  The federal estate tax is measured at death or the alternate valuation date or during life when the decedent retained specific powers or controls.  States levy inheritance taxes which are taxes on the right to receive property and are paid by the recipients.

 

An estate tax return must be filed by the Personal Representative of the estate if the gross estate is above the filing requirement.  The filing requirement is the value of gross estate, plus adjusted taxable gifts on the date of death and must exceed $ 650,000.

 

SECTION 6166A

 

Prior to the TRA 97, this Section 6166A permitted an estate to elect to defer payment of estate taxes attributable to a closely-held business, for a period not to exceed 14 years.  If this election were made, the interest charged on the first $1,000,000 of value, including the unified credit amount, was 4% per year, with the interest on additional sums due at the standard rate applicable to underpayment of taxes. 

 

Under TRA 97, the 4% rate has been reduced to 2%, and interest on value in excess of $1,000,000 is now at 45% of the underpayment of tax rate. The value upon which the 2% interest is due has also been increased to $1,000,000 over the unified credit amount.

 

However, with these more liberal provisions, it must be noted that the interest is not deductible for estate and income tax purposes.

 

SUMMARY

 

The gross estate is the total value of a person's property at the time of death.  The items included in the gross estate and their basic concepts are summarized:

 

  • Section 2033 - the gross estate includes the value of all property interests, real or personal, tangible or intangible, of an individual on the date of death to the extent of the individual's interest in the property.

 

  • Section 2033A - addresses family-owned businesses and the exclusion from the decedent’s gross estate to where the exclusion plus the unified credit does not exceed $1,300,000.

 

  • Section 2034 - states that the amount of an includible property interest in a gross estate is not lowered by the existence of dower or courtesy right.

 

  • Section 2035 - states that gifts made within three years of death are not included in the gross estate of decedents dying after December 31, 1981 except for five exceptions.

 

  • Section 2036 - provides that the gross estate includes all property transferred gratuitously by the decedent during the decedent's lifetime in which the decedent retained or reserved the right to either use, possess or enjoy the property or to receive the property's income or the right to designate the persons who should possess or enjoy the property 's income.

 

  • Section 2037 - covers transfers taking effect at death and provides that the gross estate includes the value of property transferred by the decedent for less than full and adequate consideration if the possession or enjoyment of the property can be obtained by surviving the decedent and if the decedent retained a reversionary interest worth more than 5% of the transferred property value before death.

 

  • Section 2038 - provides that if any of the powers to alter, amend, revoke or terminate or to affect beneficial enjoyment exists at death, the value of the property subject to the power is includible in the decedent's gross estate.

 

  • Section 2039 - Annuities.  An annuity is included in the gross estate when payable to decedent for life, for a period that did not end before death or for a period ascertainable only with reference to date of death.  The key to whether or not an annuity is included in the gross estate is whether or not the decedent had an enforceable right to receive payments.

 

  • Section 2040 - Joint property, jointly held property between spouses is no longer considered a gift.  Present-interest gifts between spouses qualify for the unlimited gift tax marital deduction.  Jointly held property with right of survivorship between spouses the estate of the first spouse to die will include one-half of the value of the property.  When the surviving spouse dies, 100% of the property will be included in the estate.

 

  • Section 2041 - Power of Appointment.  General Powers of Appointment are powers over property that are so broad that the power approaches actual ownership or control of the property.

 

  • Section 2042 - Life Insurance.  Life Insurance Proceeds are included in the estate if:  The decedent had any incident of ownership in the policy and if the proceeds are paid to the estate.  Also, if the proceeds are received by another for benefit of the estate.  Life Insurance proceeds do not qualify for the marital deduction if life insurance is paid to the surviving spouse but is not in decedents’ gross estate (i.e., no incidents of ownership).  Proceeds will qualify for the marital deduction if proceeds are left at the interest option for life of the surviving spouse and if payable to spouses estate or persons appointed by spouse.

 

  • Section 6166A – lowers the interest rate on estate tax deferments from 4%  

              

CHAPTER 6 – STUDY QUESTIONS

1. An estate tax is

A. an inheritance tax.

B. levied on the whole estate before the assets are distributed.

C. levied on property transferred from one spouse to the other spouse.

 

2. The purpose of Federal Estate Taxes is to

A. prevent the transmission of large estates without being taxed.

B. tax the estate and have the tax payable over a period of years.

C. tax the assets of an estate after distribution.


3. __________ ____________ is taxed is the state where the property is located.

A. Personal property.

B. Corporate stock.

C. Real estate.


4. Dower rights in property set aside property for

A. children.

B. widows.

C. husbands.

 

5. The value of property given in a trust over which the decedent retained the right to designate who may enjoy the property is

A. determined at the time of the gift.

B. includable in the grantor’s gross estate.

C. included in the decedent’s final income tax return.

 

6. If the grantor of a trust retained the power to amend the trust

A. the value of the property in the trust is included in the descendant’s (grantor’s) estate.

B. the trust is defective and without a legal purpose.

C. the trustee is released of his/her responsibilities.

 

7. If an annuity ends at the decedent’s death and payments to a beneficiary are not provided for afterward,

A. this is an annuity for a set period of time.

B. this is a straight life annuity.

C. the value would be included in the decedent’s estate.


8. An estate owner reserves a power by which he/she can appoint an interest in property to anyone without limitation, it is,

A. a power of appointment.

B. included in the owner’s estate even if the owner releases the power.

C. not a gift.

 

9. If the decedent refuses to accept a power of appointment

A. it is considered a gift.

B. the person disclaiming the power must direct to whom the power of appointment passes.

C. the disclaimer must be in writing.

 

10. An estate tax return must be filed

A. by the heir that receives the property.

B. by the personal representative of the estate.

C. even if the value of the estate is under $10,000.00.

 

 

Answers to Chapter 6 Quiz:  1B, 2A, 3C, 4B, 5B, 6A, 7B, 8A, 9C, 10B