COMPUTATION OF THE ESTATE TAX

 

 

 

NOTE:  Please see the SUPPLEMENT section at the end of this text for up-date on Estate Taxation under the 2001 Tax Law.

 

INTRODUCTION

 

As discussed in Chapter 6, the gross estate includes all property of any description and wherever located and to the extent the deceased had an interest in the property at the time of death.

 

One of the potential expenses of settling an estate is the federal estate tax.  It is a continuous lien on property, but its foreclosure date has yet to be determined.  Proper planning (Chapter 9 & 10) involves anticipating and reducing the estate tax liability wherever possible as well as providing for the payment of the estate tax.  Unlike other expenses of settling an estate, it can be quite burdensome in that it is generally due and payable in cash nine months after death. 

 

The estate tax computation is not difficult, and in many ways resembles the calculations involved in determining the income tax.  Terms such as gross income, taxable income, deduction and credits are seen are familiar because of federal income tax filing.  The estate tax computation involves the same terms.

 

HISTORY:  "THE FINAL STING"

 

The United States government's death tax is known as the federal estate tax.  Like all other taxes imposed by our system of government, this one began as a modest tax.  First seriously imposed in 1916, it had a maximum rate of ten percent.  By 1932 the maximum rate was 45 per cent and in 1981, 70 per cent.  In 1976 Congress made an attempt to initiate a reform in the death tax area;  the result was the Tax Reform Act of 1976.  Unfortunately the tax payer lost out in this change!!  The Tax Reform Act of 1976 increased the size of nontaxable estate property from $ 60,000 in 1976 through a series of expansionary leaps to $ 175,625 in 1981. 

This Act unified the federal estate and federal gift taxation law.  In effect, the Reform Act put the two together and charged identical rates.  The Act of 1976 had two distinct features.  First, federal estate tax is described as an "everything" tax.  Uncle Sam receives his tax before the beneficiaries receive anything.  Obviously the more a taxpayer owns, the more tax that taxpayer is going to pay.  The federal estate tax was designed to be a "Robin Hood" tax-take from the wealthy and redistribute that wealth to the not so wealthy.

 

For many years, up until 1976, the first $ 60,000 of estate value was not taxed.  In 1976 that amount went up in stages until it peaked at $ 175,625 in 1981.  (Today $192,800)  ^(Supp.)  This tax-free amount is referred to as the exemption equivalent. 

 

Under the Economic Recovery Tax Act of 1981 Congress raised the tax free amount to $ 225,000 for individuals dying in 1982, but by 1987 this was increased by $600,000.  Under the Tax Reform Act of 1997, it has been increased by increments for the years 1998 through 2006 and beyond.  For 1998, the amount was $625,000, for 1999 it was $650,000 and will gradually go to $1,000,000 after the year 2006 (unless legislation changes it).  ^(Supp.)

 

How much is the lifetime exception worth now?  Using the Dow Jones Industrial Average, the lifetime exemption is now worth about $175,000 in 1987 dollars.  The increases under the TRA 97 will help, but cannot compensate for the total decrease in value.

 

Congress has traditionally taken notice of the family unit and has made some allowances for leaving property to spouses in the federal estate laws.  For many years, the law provided that spouses could leave one half of their property free of federal estate tax to surviving spouse.  The Tax Reform Act of 1976 increased this espousal benefit to $ 250,000 or one half of the estate, whichever was greater.  The real change was adding a base of $ 250,000 that went tax-free to the surviving spouse.  This tax-saving spouse device we have been discussing is referred to as the marital deduction.  Property accumulated by husband and wife that was left to the surviving spouse was taxed only when it exceeded $ 425,625 (the sum of 250,000 of marital deduction and the $ 175,625 exemption equivalent). 

 

Today, the marital deduction applies to all property left to a U.S. citizen spouse - a 100% marital deduction!  But no marital deduction is available if the surviving spouse is a non U.S. citizen, unless the property passes to a "Qualified Domestic Trust" (A special trust that ensures estate assets passing for the benefit of a non-US citizen spouse are available to pay any estate taxes that may be due when the non-U.S. citizen dies) or if the surviving spouse becomes a U.S. citizen within certain strict time limit and meets some residence requirements.

Prior to ERTA, 1981, federal estate tax rates started at 18% and progressed with the size of an estate to a maximum tax rate of 70%.  The old tax rates were closely patterned after the progressive income tax rates before TRA 1986.  The concept behind these progressive rates was simple; the more successful a citizen was in accumulating property in a lifetime, the more responsibility that citizen had to share that wealth, through the government, with others less fortunate.  As property value progressively increased, the federal estate tax rates increased as well until that magic 70% bracket!!  There was no doubt that federal estate tax was predicated on the redistribution of wealth.

 

Economic Recovery Tax Act of 1981 created a radical departure from traditional policies with implementation of its concepts.  ERTA called for the maximum federal estate rate to be 50% in 1985.  Congress delayed the realization of the 50% maximum until 1993.  ^(Supp.)

 

The law now provides spouses with a massive benefit.  Today, spouses can leave any portion or all of their property federal estate tax free to their U.S. citizen surviving spouses.  There is no federal estate tax on property passing between spouses on death.  This is called the "unlimited marital deduction".  For the first time in the history of our federal estate tax Law, the government recognizes that the success created in the accumulation of property by husband and wife is the result of the joint efforts of both spouses!

 

The financial security that ERTA provided has helped, and will  continue to help the family unit survive economically.  Because of ERTA, widows and widowers are much less dependent on children and government for their economic existence.  Government has given back to the family what it had taken away and allowed spouses to keep what they have earned through a lifetime of sacrifice.  The laws changes promulgated by ERTA remain the backbone of our current law.

 

SEVEN CRITICAL POINTS

 

In summary there are seven points to remember when studying the calculation of the present day federal estate tax:

 

1.         Federal estate tax only applies to estates valued in excess of the unified credit  ($650,000 in 1999).  ^(Supp.)

 

2.         The federal estate tax rates have a maximum of 55% ( previous discussions).  ^(Supp.)

 

3.         Spouses are able to leave property to their U.S. citizen spouses free of federal

•       estate tax.

4.         The federal estate tax taxes the right to transfer almost all property interests.

 

5.         The federal estate tax applies to the fair market value of property.

 

6.         The federal estate tax is paid before the beneficiaries receive their shares.

 

7.         The federal estate tax is payable in cash nine months from date of death.

 

 

DEDUCTIONS FROM THE GROSS ESTATE

 

Adjusted gross estate is equal to the gross estate less:

 

A. FUNERAL EXPENSES  

 

Amounts that actually were spent for such expenses.  This expenses would include such costs for tombstone, monument, mortician service, burial plot, transporting the body, etc.  The key factor is if the costs are "reasonable" and are allowed as a charge against the estate under state law.

 

B. ADMINISTRATIVE EXPENSES

 

Concerning the estate which could include court costs, Executor's commission, attorney's fees, accounting fees, miscellaneous costs to properly settle the estate and medical expenses of decedent's last illness (this could be included as income tax deduction instead).  The major requirement for deductibility is that the expense must be necessary, essential, actually incurred, and reasonable with respect to settling the estate.

 

If an expense is forbidden by state law to be paid out of estate assets, it is generally not deductible by the estate for federal estate tax purposes.

 

C. CLAIMS AGAINST THE ESTATE  

 

Are any bona fide debts incurred by the decedent before death and are certain taxes deductible from gross estate?  Deductible taxes would include the federal income taxes and also the state, local, foreign income taxes and property taxes (these could also be deducted on the federal income tax return but not on both), also real estate taxes and local, foreign income taxes on estate income.

 

 

 

D. MORTGAGE DEBTS 

 

Mortgage debts will be allowable as deductible estate tax expenses if the full value of the property not reduced by the mortgage is included in the gross estate and if the estate is liable for the mortgage debt.

 

E. LOSSES

 

Casualty and theft losses may not be claimed if compensated by insurance and may not be claimed on both state tax and estate income tax forms.

 

F. OTHER ADMINISTRATIVE EXPENSES

 

Included in this category are funds used to settle non-Probate assets (life insurance and jointly held property).

 

Note:  There are two basic decisions the Executor must make when claiming the various expenses to estate tax purposes.

 

• Whether to take a deduction on the Federal Estate Tax or income tax Return (e.g., medical and casualty deductions can be taken on either).  One solution could be to split the deduction -medical expenses from the income taxes and the casualty losses from estate tax form.

 

• Whether the Executor wishes to waive the Executor's fee if Executor will also receive a bequest which is income tax free,  The fee is considered ordinary income.

 

 

Once these expenses have been calculated, we have arrived at the adjusted gross estate.

 

(Please refer to "Estimating Your estate tax liability" worksheet at the end of the chapter.) 

 

BACKGROUND OF THE MARITAL DEDUCTION

 

In the past the community property states only called for one-half of the community held property to be included in the estate of the spouse who died first.  Residents of the common law states were envious of this preferential tax treatment so Congress gave a federal estate tax marital deduction to married residents in the common law states.  The Economic Recovery Tax Act achieved tax parity by allowing an unlimited deduction for assets passing from one spouse to another, either during lifetime or at death.  The Unlimited Marital Deduction applies in both Community and common law states.  Please remember that the marital deduction is not a device to avoid taxation but defers taxation until the death of the second spouse.  As stated before, Congress's goal was to treat spouses as one unit for transfer tax purpose and only tax one estate.  Presumably, without proper planning, the second estate will be much larger than the first estate thus rendering more estate taxes.

 

MARITAL DEDUCTION BASIC RULES

 

As may be expected there are numerous roles that govern the use of the marital deduction, with some exceptions.  The seven basic rules are:

 

GENERAL RULE: 

The estate tax marital deduction is given on the full net value of a qualifying interest passing to a decedent's surviving spouse but will be reduced by any taxes that are payable out of the marital share of the estate.

 

NET VALUE OF GROSS ESTATE:

Is the gross estate tax value of property interest at date of death (or at alternate - valuation date) less any charges against the property interest.

 

Three charges against property interest could be:

 

•   Mortgage/Liens against the interest.

 

• Administrative expenses payable out of the interest.

 

•   Taxes payable out of the interest (Federal Estate Tax, state death tax).

 

 

PROPERTY PASSAGE: 

 

Property must pass or have passed to the surviving spouse.  A property interest owned by the decedent must pass from decedent to the surviving spouse and the surviving spouse must receive that interest as the beneficial owner (not as a trustee or as someone's agent).  Property may "pass" from the decedent to the surviving spouse in many different ways, and still qualify for the marital deduction.  Some of these ways are:

• Life insurance proceeds.
• Under the intestacy laws.
• Under the decedent's Will.
• Joint tenancy property, by right of survivorship.
• Tenancy by the entirety property, by right of survivorship.
• Under a General Power of Appointment.
• Under the spouse's right to elect against the Will.
• Under a dower or courtesy interest.
• As lifetime gift to the spouse that is brought back into the decedent's gross estate.
• As "Qualified Terminable Interest Property” (Q-TIP).

 

 

 

RESIDENCE OR CITIZENSHIP REQUIREMENT: 

 

The deceased spouse must  have been a citizen or resident of the United States to qualify for the Marital Deduction and transfer must be made by a decedent who was at the date of death a U. S. citizen/resident.  In general, a marital deduction is not available if the surviving spouse is not a U.S. citizen unless property passes to the surviving spouse in a qualified domestic trust.

 

INCLUSION OF PROPERTY REQUIREMENT: 

 

To be eligible for the marital deduction, the property must meet all requirements for being included in the gross estate. 

 

 

MARITAL STATUS REQUIREMENT: 

 

Spouses must be married, not divorced.  A legal separation does not change the surviving spouse's status (the marriage was not legally terminated by the date of death).

 

In case of a common disaster there are two methods of determining who died first (who was the surviving spouse):

 

1.     A presumption - of - survivorship clause may be used in the Will/life insurance settlement option (e.g., husband declares that if there is no evidence to determine who died first, "my wife shall be deemed to have survived me").

 

2.     Uniform Simultaneous Death Act  which states if there is no presumption-of-survivorship clause, each decedent's estate will be distributed as if decedent were the survivor (husband's Will is Probated as if he survives his wife and wife's Will is Probated as if she survives her husband).  This results in the loss of marital deduction.

 

TERMINABLE INTEREST RULE: 

A marital deduction is allowed only when the interest passed to the surviving spouse is one that, if kept until that spouse's death, will be taxed to the surviving spouse's estate.

 

 

 

DISQUALIFICATION RULES

 

A terminable interest may be disqualified if all three of the following conditions exist:

 

• The other person (or heirs) could posses/enjoy any part of the property at termination of the surviving spouse's interest.

 

• The interest passed to the other person for less than adequate and full consideration in money or money's worth.

 

• Another interest in the same property passed to some one other than the surviving spouse.

 

 

 

EXAMPLES OF TERMINABLE INTERESTS:

 

1.     Patents and Copyrights.

 

2.     Life Estate and Annuities.

 

3.     "To wife during widowhood."

 

4.     "To my wife for life.  Remainder to our children."

 

5.     "To my wife for Life."

 

 

Exceptions to the Terminable Interest Rule

 

• A qualified terminable interest property election qualifies.

 

• A life insurance policy payable to the surviving spouse in which that spouse has a General Power of Appointment over the proceeds qualifies.

 

• A bequest for a life estate paired with a General Power of Appointment ("Power of Appointment Trust") qualifies.

 

This is the most common methods of qualifying property in trust for the marital deduction.  The power of Appointment Trust is designed to hold assets for the surviving spouse and to provide that spouse with a General Power of Appointment over the principal.  Five requirements are needed to qualify:

 

1.     Surviving spouse has claim to entire income from trust.

 

2.     Income is paid at least once a year.

 

3.     Spouse can exercise the power to appoint corpus to self.

 

4.     Power must be exercisable only by the surviving spouse.

 

5.     Only the surviving spouse has power to appoint any part of corpus to anyone other than the surviving spouse.

 

Final exception to the terminable interest rule: an interest will still qualify for the marital deduction if the bequest to the surviving spouse was conditioned upon the spouse surviving for up to six months after the decedent's death and spouse does survive.

 

 

TRUSTS AND THE MARITAL DEDUCTION

 

Chapter 9 is devoted to trusts, but a discussion of three popular marital deduction trusts should be discussed in this section. 

 

In the previous section, the Power of Appointment Trust was discussed.  This section will discuss the Estate Trust and Qualifying Terminable Interest Property Trust in this section.

 

A marital trust is a spouses trust.  It is designed to hold assets that would qualify for the marital deduction.  These trusts would include the General Power to Appoint and would obligate that the property in the trust would be income producing.  A non-marital trust is commonly a family trust, which provides management for assets which would be taxable at testator's death.

 

ESTATE TRUST

 

As an alternative to the Power of Appointment Trust, the Estate Trust gives the surviving spouse an interest for life, with the remainder payable to the spouse's estate.

 

ADVANTAGES OF ESTATE TRUST

 

1.         Trustee can accumulate income within the trust.  all income does not have to be paid annually to surviving spouse.

 

2.         Trustee can invest in unproductive property/retain unproductive asset.

 

3.         Protection against a spendthrift spouse.

 

4.         Income tax savings.

 

5.         Assets available to surviving spouse's Executor at death.

 

6.           Lifetime assignments of trust property may not be made by surviving spouse.

 

DISADVANTAGES

 

1.     Increased administration costs.

 

2.     Liable to claims of creditors.

 

3.     Subject to state inheritance taxes.

 

4.     Restriction on disposal of trust property by surviving spouse during lifetime

 

5.     No freedom of surviving spouse to use/manage trust assets.

 

QUALIFYING TERMINABLE INTEREST PROPERTY TRUST (Q-TIP)

(See SUPPLEMENT section for discussion of this trust with new tax laws)

 

Four requirements must be met for the Q-TIP Trust to qualify for a Marital Deduction Trust:

 

1.     Decedent spouse/donor must make a transfer of property.

 

2      Surviving spouse/donee must be entitled to all the income for life;  the income must be payable at least annually.

 

3.     No one can be given the right to direct that the property will go to anyone (other than the surviving spouse) as long as the spouse is alive.

 

4.     The Executor appointed by the first decedent spouse must make an irrevocable election on the decedent's Federal Estate Tax return, providing that the value of whatever Q-TIP property is left at the death of the surviving spouse will be included in the estate (i.e., the remaining property's value at surviving spouse's date of death).

 

ADVANTAGES OF Q-TIP TRUST

 

1.     Protection against creditors.

 

2.     Avoidance of Probate of trust principal at death of the surviving spouse.

 

3.     No power for surviving spouse to dispose of the property.

 

4.     Grantor assured that trust assets will go to those the grantor selects.

 

5.     A spendthrift spouse cannot consume assets.

 

DISADVANTAGES

 

1.     False sense of security that estate owner's objectives will be realized.

 

2.     Assets use restricted.

 

3.     Non-income producing property can only be used to fund the trust if the surviving spouse is granted power to demand that the assets be made productive.

 

FORMS OF MARITAL BEQUESTS

 

 

OUTRIGHT BEQUEST 

 

An outright bequest is a direct transfer of property to the surviving spouse through life insurance proceeds or in a Will.

 

In a Will a clause could be inserted that gives a formula for determining the shape of the asset that will make the most efficient use of the estate owner's unified credit.  (more on this in Chapter 10).  There are two types of Formula Bequests.

 

A.    PECUNIARY (DOLLAR) AMOUNT BEQUEST

The survivor will receive a fixed dollar amount (would take into consideration all property qualifying for the marital deduction).

 

B.    FRACTIONAL SHARE BEQUEST

The survivor will receive a fractional share of each asset in the estate, after specific bequests have been made.

 

ADVANTAGES OF MARITAL BEQUESTS

 

1.     Spouse may use/manage assets at spouse's discretion.

 

2.     Discourages spouse from electing against the Will.

 

3.     Non income-producing assets may be transferred.

 

4.     Trustee's fee/court accounting eliminates.

 

5.     Assets received by spouse are available to spouse's Executor to satisfy liquidity needs.

 

DISADVANTAGES

 

1.     Surviving spouse can exclude children and favor a second spouse in disposing of bequest.

 

2.     Spendthrift spouse may consume assets.

 

3.     Creditors can attach the bequest.

 

4.     Assets not consumed/given away will be included in surviving spouse's Probate estate.

 

5.     No management.

 

As discussed in the text on the marital deduction, the gift tax marital deduction is allowed for gifts of interest in property (including cash) between spouses in an amount equal to the value of such gifts made after 1981.

 

Outright gifts to the spouse qualify for this deduction.  However, the marital deduction cannot be taken if the gift is of a life estate or other terminable interests unless it meets certain statutory requirements for qualification.  These are the same requirements necessary to qualify a terminable interest for the estate tax marital deduction.  The marital deduction will also apply to the value of a donee's spouse's income interest in a qualified remainder trust created by the donor spouse if the donee spouse is the only non-charitable beneficiary of the trust.

 

If the spouse of the donor is not a United States citizen, the marital deduction is not available for a transfer to such spouse.  However, in this situation, the annual exclusion for the transfer from the donor spouse to the non-citizen spouse is increased from $90,000 to $100,000 (provided the transfer would otherwise qualify for the marital deduction if the donee spouse were a U.S. citizen).

 

 

CHARACTERISTICS OF CHARITABLE DEDUCTIONS

 

Individuals also may make estate tax charitable deductions for qualified charities.  There are four qualified charities:

 

1.   Corporations that are operated solely for religious, charitable, literary and educational purposes.

 

2.   Fraternal societies/orders that use charitable contributions solely for charitable purposes.

 

3.   United States/District of Columbia/State/ Political subdivision that use contributions solely for public purposes.

 

4.   Veterans organizations incorporated by Act of Congress or such organizations.  Departments/posts or local chapters.

 

CHARITABLE DEDUCTION DENIALS

 

A charitable deduction will be denied if (1)  the charitable beneficiary uses contributions for non-charitable purposes, (2)  if the gift is contingent upon occurrence of some events (unless the change of the events actual occurrence is nil), (3)  the organization participates in political campaigns or other prohibited transactions, (4)  any net earnings of the organization benefit an individual or private stock holder, or (5)  the organization's chief activity is influencing legislation.

 

 

TYPES OF CHARITABLE BEQUESTS

 

There are nine types of charitable bequests which may be made by Will to transfer gifts:

 

• Split gifts are made between a spouse and charity.  The donor-decedent can create a charitable remainder trust and receive both the charitable deduction (for the charitable bequest) and the marital deduction (for non-charitable bequest to spouse).

 

• Gift of art without copyright.  A charitable deduction is allowed for transfer of artwork to charity even though the copyright covering artwork is not transferred.

 

• Power of Appointment.  A charitable deduction is given for property included in the decedent's gross estate due to a General Power of Appointment decedent had over the property that passes to a charity because of an exercise/lapse/release of that power.

 

• Partial Interests:  Charitable deduction is given for fractional interests that passes to a charity.  There are four types of partial interests:

 

A.     Testamentary gift of an undivided share of the decedent's entire interest in property not held in trust.

 

B.     Remainder interest in a personal residence/farm transferred by decedent at death.

 

C.     Remainder interest in a trust to charitable remainder trusts and pooled income funds.

 

D.     Transfer of a fractional interest in property to a charity solely for conservation purposes.

5.  Charitable Remainder Trusts.  For charitable deduction to be allowed,   decedent's transfer of a remainder interest in property to a charity in trust must be made in one of the following three forms:

 

• Charitable Remainder Uni-trust.

 

• Annuity Trust.

 

• Pooled Income Fund.

 

 

6.  Charitable remainder.  Uni-trust pays a set percentage worth not less than 50% of the net fair market value of the trust assets as annually revalued.  Compare with Annuity Trust.

 

SIMILARITIES:

 

1.        Both require annual payments to non-charitable beneficiaries with the eventual transfer of remainder interest to a qualified charity.

 

2.        Both may be created by Will or during lifetime.

 

DIFFERENCES:

 

1.      In an Annuity Trust, if trust income is inadequate to cover the annual payment, the beneficiary must be paid out of principal;  in a Uni-trust ^(Supp.), payments can be made from income only.

 

2.      In an Annuity Trust, no additional contributions can be made to the trust after the initial payment;  in a Uni-trust, further contributions are allowed.

 

3.      Annuity Trust pays a set annuity worth not less than 5% of the original net fair market value of the property paid in trust.  Payment must be made at least annually to one or more non-charitable beneficiaries who are alive at time trust was created.  When the last income beneficiary dies (or after a set number of years, not to exceed 20 years), remainder interest must go to a qualified charity.

 

7.   Pooled Income Funds.  Similar to a Mutual Fund which is established for the qualified charity.

 

8.   Guaranteed annuity interest (charitable lead trust).  Right to receive determinable amount at least annually for a fixed term.  Income interest in property is transferred by decedent to a charity;  remainder would go to a non-charitable beneficiary.  A charitable deduction is allowed if the income interest is in the form of a Uni-trust interest/guaranteed Annuity Interest.

 

 

VALUATION OF CHARITABLE GIFTS

 

Partial interest is valued at fair market value of the interest on the appropriate valuation date (date of gift/date of death).

 

• Remainder interests in charitable remainder Annuity Trust/Uni-trusts/Pooled Income Funds.  Value determined by I.R.S. regulation.

 

• Guaranteed annuity interests.  Value determined by estate tax regulation.

 

• Uni-trust interests.  Fair market value of the transferred property minus present value of all interest in that property (other than the Uni-trust interest).

 

ADJUSTABLE TAXABLE GIFTS

 

The Taxable Estate is the Adjusted Gross Estate, less the Marital and Charitable deduction.  Before the Federal Estate Tax can be determined, one more adjustment must be made.  Adjusted taxable gifts are those gifts made during life after 1976 on which a gift tax was paid and must be added back in the estate.  Taxable gifts are future-interests gifts or those in excess of the $10,000 annual exclusion ($3,000 annual gift tax exclusion for gifts made after 1976 and prior to January 1, 1982; $10,000 annual gift tax exclusion for gifts made after December 31, 1981).  Keep in mind that completed gifts made within three years of death will not be included in the decedent's gross estate.  Any taxable gift made after 1976 will be brought back into the estate tax calculations as an adjusted taxable gift. 

 

EXCLUSIONS

 

There are four exclusions from treatment as adjusted taxable gifts:

 

1.     Post 1976 gifts within the amount of the annual exclusion.

 

2.     Gifts made to a spouse that qualified for the gift tax marital deduction.

 

3.     Gifts that qualified for the gift tax charitable deduction.

 

4.     Gifts that have already been included in the decedent's gross estate.

 

TENTATIVE TAX BASE

 

Once the adjusted gifts are added to the taxable estate, the last step before calculating a tentative tax base is to subtract any charitable gifts made, including those that will take place upon death through trusts or provisions in the Will.

 

Gift taxes on post-1976 gifts in excess of the unified credit are subtracted, which results in estate tax payable before the credits.  The four steps to remember in this reduction would be:

 

• the total of all post - 1976 taxable gifts.

 

• to compute the gift tax payable by applying the unified rate schedule in effect a decedent's death to the total taxable gifts.  (see chart).

 

• reduce gift tax by allowable unified credit.

 

• if the gift tax payable exceeds allowable unified credit, subtract the excess from the tentative tax.

 

 

FEDERAL ESTATE TAX CREDITS

 

There are five tax credits available to a decedent.  The federal estate tax credit is a  dollar-for-dollar reduction of the tax after the unified rates have been applied to the sum of the taxable estate plus adjusted taxable post-1976 gifts.  We will discuss in detail the effect of estate death taxes and the Unified Credit.

 

1.  PRIOR TRANSFER TAX 

 

Where a person transferred property that was taxed at death to the current decedent and the property is included in the gross estate, a credit will be allowed for all or part of the estate tax paid by the first decedent.  This will prevent double taxation on the property.  This credit reduces every two years;  at the end of ten years after death of the first person no credit is allowed.  There are two requirements:

 

• Property must have been included in the first person estate and must have transferred to the current decedent.

 

• Transfer can be of any type (e.g., gift, by Will, life insurance proceeds).

 

2.  FOREIGN DEATH TAXES 

 

For property that is included in the decedent's gross estate and situated in a foreign country or a United States Possession, a credit is allowed for death taxes paid.  The purpose is to prevent double taxation. Credit is allowable only to the estate of a decedent who was either a U.S. citizen or a resident who was a citizen at the time of death.

3.  GIFT TAX PAID ON PRE-1977 GIFTS 

 

Gift tax payable on post-1976 gifts becomes part of the computation for determining tax liability under the unified gift and estate tax system so a separate credit is not allowed for taxes attributable to these gifts.  A credit still exists for federal gift tax paid by a decedent on taxable gifts made before 1977 if the property is included in the gross estate.

 

 

4.  STATE DEATH TAXES 

(Note discussion of State Death Taxes as they relate to Tax Act of 2001 in SUPPLEMENT section at back of this text).

 

All state's death-tax laws fall into one of three general death tax categories.  (1)  States which collect their taxes directly from the Federal Government (GAP-Tax States);  (2)  States which tax the estates of their citizens much like the Federal Government does (estate-tax states);  and (3)  States that base their death taxes on the value of the property that passes to certain defined beneficiaries (inheritance-tax states).

 

      GAP TAX STATES: The Federal Government's estate-taxes tables allow as a credit against Federal Estate Tax certain dollar amounts that can be paid to the individual state instead of to the Federal Government.  The federal estate-tax tables spell out what the tax will be, bracket by bracket, for different sized estates.  These same tables provide that a small percentage of the federal estate tax will be forgiven if that amount is paid to the state in which the deceased citizen resident pursuant to that state's death tax laws.  These gap-taxes states only receive death-tax revenues that would have gone to the Federal Government anyway but for the state gap tax.  A portion of the Federal Estate Tax is paid to the gap-tax state instead of all tax being paid to the Federal Government.  The gap-tax states are:

 

Alabama                               Florida

Alaska                                  Georgia

Arizona                                Hawaii

Arkansas                              Idaho

California                             Illinois                       

Colorado                              Maine              

South Carolina                     Wisconsin

Minnesota                            Texas

Missouri                               Utah

Nevada                                 Vermont

New Mexico                         Virginia

North Dakota                       Washington

Oregon                                 West Virginia

Rhode Island                       Wyoming

 

 

CREDIT FOR STATE DEATH TAXES

The state death tax credit applies only to adjusted taxable estates in excess of $40,000.

 

TAX CREDIT ON PRIOR TRANSFERS

 

This tax credit applies in those situation where there was all or part of the estate tax paid on property by the present decedent that he/she had received from another decedent who had died within 10 years of the present decedent’s death, or two years after the present decedent.  This tax credit is the estate tax that had been paid by the original decedent, multiplied by the ratio of the transferred property’s value to the value of the transferor’s taxable estate.

 

This may seem complicated, but it can be better understood using the illustration in the following Consumer Application:

 

 

However, if the current decedent died within 2 years before or after the other decedent all (100%) of the prior tax paid may be taken as a credit. 

If more than two years have elapsed since the other decedent’s (Floyd’s) death, the credit must be reduced according to the following scale:

 

No. of Years Passing since                       % Reduction of Credit

Transferor’s Death

3-4                                                                                                   20%

1.                                                                                               40%
2.                                                                                               60%

9-10                                                                                                 80%

     More than 10                                                                                     100%

 

This means that if a person dies more than 10 years after receiving property from an estate, the credit for prior transfers disappears.  If a surviving spouse doesn’t remarry, any property he/she receives will be subject to full estate taxation at death, provided that he or she lives more than 10 years after death of the first spouse.  The absence of a marital deduction at the second death can cause assets to be taxed twice by being taxed once in the first spouse’s estate, and then again in the survivor’s estate if some property was subject to tax at the first death by choice.

 

Any property that is passed to a spouse and qualified for the marital deduction, does not qualify for the tax credit for prior transfers because it generated no prior taxes.  This means that property passed subject to the marital deduction will almost certainly be taxed in the estate of the surviving unmarried spouse – regardless when that spouse dies.  If he/she dies after ten years has passed since the death of the first spouse to die, all of the property owned (or controlled) by the survivor will be fully subject to tax. 

 

The burden of estate taxes most often falls on the estate of the second spouse to die.

 

ESTATE-TAX STATES:

Some states tax the estates of their deceased citizens under death-tax systems which are structured very much like the Federal Estate Tax.  These states apply their own unique tax rates and have their own unique sets of rules as to how their rates will be applied.  These states also get the benefit of the federal estate tax Revenue Sharing Program.  Unlike gap-tax states, these states not only get revenue under the Federal Estate-Tax Revenue Sharing Program but also collect substantial additional funds as a result of their death taxes.  The state tax rates are always higher than the amount from the Federal Estate Tax Revenue Sharing Program.  These States are:  Massachusetts, Mississippi, New York, Ohio and Oklahoma.

 

INHERITANCE-TAX STATES:

These states apply their death-tax rates against the value of the shares that pass to certain defined classes of beneficiaries (See chart).  Because the state death tax is calculated on the share that each beneficiary will receive or inherit, it is called an "Inheritance Tax".  These states have different tax rates that apply to different kinds or classes of beneficiaries.  The closer the beneficiary's blood relationship is to the deceased the lower the inheritance-tax rate will be.  These states also receive funds from the Federal Estate-Tax Revenue Sharing Program. 

 

About 2/3 of the states have a pick-up tax law whereby a state can enjoy participation in the federal estate tax.  Using this tax, states can take part of the federal tax levy, so while they have “no inheritance tax law”, it means that they take part of the amount that is calculated as federal estate tax.  These states are:

 

Alabama, Alaska, Arizona, Arkansas, California, Colorado, District of Columbia, Florida, Georgia, Hawaii, Idaho, Illinois, Maine, Minnesota, Missouri, Nevada, New Mexico, North Dakota, Oregon, Rhode Island, South Carolina, Texas, Utah, Vermont, Virginia, Washington, West Virginia, Wisconsin, Wyoming.

 

The other states impose a state death tax, either inheritance tax or estate tax.  The maximum tax in each of these states is:

 

Connecticut                        14%     Kansas       15%

Delaware    16%                Kentucky          16%

Indiana       15%                Louisiana          10%

Iowa            15%                Maryland          10%

Michigan     17%                New Jersey       16%

Montana     32%                N. Carolina       17%

Nebraska     18%                Pennsylvania     15%

New Hampshire15%          South Dakota   30%

Tennessee   13%                Massachusetts   16%

Mississippi  16%                 Oklahoma         15%

New York     21%               Ohio                   7%

 

State death and gift taxes change from time to time.  The amount of this credit is determined from the table.  The amount the taxpayer enters uses from the table is equal to the deceased's taxable estate minus $60,000.  This is the deceased's adjusted taxable estate.  The credit allowed cannot exceed the state death tax actually paid, and if those taxes exceed the maximum credit, only the credit amount allowed by the table may be claimed.

 

 

See credit for “state death taxes” chart and “state inheritance-tax” table at the end of the chapter.

 

 

 

5.  UNIFIED CREDIT 

 

The Unified Credit was mentioned earlier in discussing applicable IRS regulations that affect Estate Planning.  ^(Supp.)

Previously, the unified credit was $192,800, which eliminated taxes on a total of $600,000 of taxable gifts and taxable estate.  These amounts were increased for gifts made, and for estate of decedents dying, after 1997.  The following table shows the unified credit and the applicable exclusion amount for the calendar year in which a gift is made or a decedent dies.

 

 

You will note that increases are small in the first several years, (during a time when the numbers are being used to project a balanced budget) and the increase in the last three years.  With the prospect of a “surplus” in the Federal Government income, one may expect that these amounts will change.  As mentioned in the beginning of this text, the Federal Inheritance Tax may become a thing of the past – or it may not. 

 

This is a tax credit available to every donor, which may be drawn upon as needed to offset gift taxes otherwise payable.  The maximum credit is set at $211,300 (for year 1999).  To generate this much gift tax liability, a donor would have to make total taxable gifts during his/her life of $ 650,000 (after all annual exclusions and deductions were taken).  Of course with gift splitting available to a married donor, up to $1,300,000 of total taxable gifts to third parties may be protected by the unified credits of husband and wife.  Other factors about the unified gift tax credit:

 

A.    The credit may be drawn upon as needed to offset gift tax otherwise payable.

 

B.    Only the amount required to offset the gift tax due can be claimed as a credit.

 

PHASE OUT OF GRADUATED TAX RATES AND UNIFIED CREDIT

 

Beginning with gifts made on and after 1/1/88 the tax benefit of the unified credit and the graduated Gift tax rates is phased out for larger gifts.  There is a 5% surtax on taxable gifts exceeding $ 10 million up to $ 21,040,000, at which point the benefit of the unified credit and graduated rates is completely eliminated.

 

 

 

UNIFIED  CREDIT  AND GRADUATED RATES PHASE OUT 

 

Beginning with estates of persons dying on and after 1/1/88 the tax benefit of the unified credit (and the graduated estate and gift tax rates) is phased out for larger estates.  There is a 5% surtax on taxable estates exceeding $10 million up to $21,040,000, at which point the benefit of the unified credit and graduated rates is completely eliminated.  The rate of tax on taxable estates of $21,040,000 and above is a flat 55%.

 

Now that the credits have been subtracted from the taxable estate the final calculation is ready to be made.  Upon arriving at the taxable estate the estimated Federal Estate Tax is calculated by using the chart.

 

Payment of the Federal Estate Tax is due nine months after the decedent's death;  this is the same time the tax return must be filed by the Personal Representative if the estate is large enough.  An extension of up to twelve months may be given for reasonable cause as determined by the IRS.  Taxes may be deferred in a closely held business if that business consists of 35% or more of the Adjusted gross estate.  Payment of these taxes may be deferred for five years from the due date,  then tax plus installments on the paid balance is payable over a maximum of ten years.

GENERATION – SKIPPING TRANSFER TAX

(Please see SUPPLEMENT section in back of text for discussion of GST and Tax Act of 2001.)

In addition to the concerns regarding federal estate tax, state and local inheritance taxes, there is another transfer tax named “General Skipping Transfer Tax.”

 

Because of greater longevity, many families now have four or even five generations still living at the same time.  The Federal government believes that the federal government deserves its tax each time one generation dies. 

 

If, for instance, a person that owns a large taxable estate were to give or leave his estate to grandchildren or great-grandchildren (not at all uncommon) or even for trusts for their benefit, he would therefore avoid a gift or estate tax.  This, according to the government, would deny the government its tax that is rightfully theirs – or at least delay the payment of such tax.  Therefore, the officials in Washington created another tax, called the “Generation Skipping Transfer Tax.”

 

And if that isn’t bad enough, the tax was set an unbelievably high level, estimated by one writer at 140%!

 

However, the law allows an exemption of $1,000,000 from this tax.  (Whew!)  So therefore a doting grandparent can give their grandchild as much as $1 million, in life or in death, or in a combination of lifetime and at-death transfers, and still pay no Generation Skipping Transfer Tax.

 

The rules are complex and if the person has a highly taxable estate, the assistance of the accountant should be obtained, but a person could profit by the use of this particular tax.

 

This tax, as others, does not apply to charitable gifts.

 

FEDERAL ESTATE TAX SUMMARY

 

To summarize the effect of Federal Estate Taxes, when a person dies in possession of a taxable estate, the Executor or the Trustee must file a Form 706 (Federal Estate Tax Return) and must pay any tax due.  The estate may be valued either at the time of death or within six months of death.

 

Every asset, whether it be money, securities, jewels, real estate, or anything else of value that can be considered an “asset”, is subject to the Federal Estate Tax.

 

Typical Taxes for 1998

                      Value of Estate                                        Federal Estate Tax

$750,000                                                      $  46,250

$1,000,000                                                     143,750

$2,000,000                                                     578,250

$3,000,000                                                  1,088,250

(Please see SUPPLEMENT at back of text for details of taxes with 2001 Tax Act.)

There are four basic ways to AVOID Federal Estate Tax.  This text discusses all of these in detail, but for emphasis, they are reiterated here.  Please note that there are other ways of decreasing, limiting, or delaying Federal Estate Taxes, must of which are discussed later in the text.

 

1. Spousal Transfers:   There is no Federal Estate Tax on transfers between spouses, whether while living by gift, or at death by legacy.

 

1. The Lifetime Exemption:  Every person has a lifetime exemption from taxation of $650,000 (in 1999) that can be used during life or at death, but not at both.  *See the discussions of By-Pass trust.

 

1. Annual Exclusion Rule:  Each donor can give $10,000 to as many persons each year as they wish.  If more than $10,000 is given, a Federal Gift Tax Return form 709 must be filed.  Please Note:  Effective under the Tax Relief Act of 1997, the $10,000 per person annual exclusion is increased according to the increase in the interest rates, but with a minimum increase of $1,000.  During 1998 and 1999, and perhaps later years, the rate of inflation is so low that a $1,000 increase has not occurred.  In this text, the figure of $10,000 will be used for illustrative purposes without this explanation of probable increase in the future.

 

1. Charitable Giving:  There is no Federal Gift or Estate Tax on gifts made to legitimate charitable organizations.

 

*As an example of saving taxes, by using a By-Pass trust, a married couple ensures that their lifetime exemptions are fully utilized which can result in a tax savings (depending upon the size of the estate, of course) of nearly $250,000.

 

Annual gifts, which are made to people, or to trusts, can reduce the taxable estate and can save as much as $5,500 each time a gift of $10,000 is made.

CALCULATING ESTATE GROWTH

 

Finally, when planning an estate, it should be considered in two ways.  First, calculating the tax on the amount of the taxable estate at the present time must be accomplished, as discussed above.  However, there should be a tax calculation on the future value of the estate.

 

In order to determine future growth, one must just remember the number 72 .  If assets are growing at a compound rate of, for example, 8%.  Simply divide:  8 into 72 equal 9.  Therefore, the assets will double in value in 9 years.  Further, if one is making 6% on his investments, it will double in (72 divided by 6 equals 12) 12 years.  Obviously, if one is making 7.2%, it will take 10 years to double the investment, or $100,000 would be worth $20,000 in 10 years, $40,000 in 20 years, and $800,000 in 30 years!.  The magic of compound interest.

 

Further, American’s are living longer, so assets will have a longer period of time to accumulate.  A male child is now expected to live 75 years – a baby girl is now expected to live 78 years.  Examples of life expectancy for American males are:

 

Present Age                                                      No. of Years Expected to Live

1.                                                                                               26 years
2.                                                                                               18 years

70                                                                                                  12 years

       80                                                                                                   7 years

       90                                                                                                   3 years

 

The combination of longer life expectancy and the growth of taxable estates, creates some very large taxable estates. 

 

                    

CHAPTER 7 – STUDY QUESTIONS

1. The Tax Reform Act of 1976

A. made estates of U.S. Citizens exempt from Federal Estate Tax.

B. imposed an estate tax that had a rate of 10 percent.

C. unified the federal estate and federal gift taxation law.

 

2. The Tax Reform Act of 1976 created a tax-saving spouse device known as

A. the marital deduction.

B. dower rights.

C. unified credit.

 

3. Under Federal Estate Tax laws, spouses are able to leave property to their U.S. Citizen spouse free of

A. inheritance tax.

B. federal estate tax.

C. income tax.

 

4. The Adjusted Gross Estate is the gross estate less one of the following deductions

A. Marital deduction.

B. Funeral expenses.

C. Charitable deduction.

5. The purpose of the unlimited marital deduction is to

A. treat spouses as one unit.

B. tax the estate of the first spouse to die.

C. reduce the adjusted gross estate.

 

6. To be eligible for the marital deduction spouses

A. may be separated.

B. may be divorced.

C. must live in the same state.

7. A charitable deduction will be denied if

A. the donation is not cash.

B. the local pastor uses the contribution for himself/herself.

C. the contribution is made to a state university.

8. A Federal Estate Tax credit

A. is used by spouses to transfer property between them tax-free.

B. is used by individuals who wish to leave a contribution to their church upon death.

C. is a dollar-for dollar- reduction of tax.

9. Payment of the Federal Estate Tax is due,

A. nine months after the decedent’s death.

B. at the decedent’s death.

C. on April 15th of the year following the decedent’s death.

 

10. The unified credit can be used

A. to eliminate income taxes.

B. by a donor to offset gift taxes otherwise payable.

C. to eliminate state inheritance taxes.

 

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