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Frequently Asked Questions and Terms regarding Estate Tax Planning

Orlando, FL Estate Planning Law Firm


The Estate Tax

Federal estate taxes are imposed on the transfer of wealth at death. The calculation of the estate tax is based on the value of a decedent’s “Gross Estate.” The Gross Estate can be loosely defined as the value of all property in which the decedent had an interest at the time of his death (plus certain other statutorily mandated items).

Who is Subject to the Estate Tax?

The estate tax is imposed on the taxable estate of every decedent who is either a citizen or resident of the United States. [IRC §2001(a)]. The determination of the amount of estate tax due is, like most taxes, based on the computation of a taxable amount multiplied by a progressive tax rate. , the estate tax rate is 45%.

The determination of the taxable amount is a bit complicated because of the Congressional intent to create a unified estate and gift tax structure. The complications might be a bit easier to grasp if one understands the Congressional thinking first. Since the estate tax rates are progressive, Congress was not content to tax lifetime gifts separately from amounts transferred at death. To permit this would enable an individual to obtain lower estate tax rates by making lifetime transfers. The intent is to tax all gratuitous transfers, regardless of whether such transfers were made during life or at death, according to a unified tax rate structure. Accordingly, the estate tax is tentatively computed based upon the sum of the taxable estate plus the “adjusted taxable gifts”. [IRC §2001(b)].

For those who are technically inclined and who actually read Section 2001(b) of the Internal Revenue Code, such persons will notice that the definition of “adjusted taxable gifts” includes only taxable gifts made by the decedent after December 31, 1976 (and other than gifts which are includable in the gross estate of the decedent). This is because the unified approach to estate and gift taxes was first enacted in 1977 and the law was applied prospectively. The technically inclined will also notice that the tentative tax computation is intended to impose a tax at the highest marginal rate. Since all lifetime gifts are included in the computation, it is only proper that the amount of this tax be reduced by the amount of gift taxes that would have been payable on post-1976 gifts. This reduction for gift taxes payable yields the total amount of estate tax due, after which certain credits against the estate tax are allowed in order to determine the net tax payable. [IRC §2001(b)].

Who is Liable for Payment of the Estate Tax

The executor or personal representative of the decedent’s estate is liable for payment of the estate tax. [IRC §2002]. This liability applies to the entire tax, even though property which contributes to the tax liability does not comprise part of the probate estate (and hence, does not come within the possession of the executor). In all cases where the Gross Estate exceeds $3,500,000 (under the law in effect in 2009), a Form 706, estate tax return, must be filed. [IRC § 6018(a)]. The estate tax return must be filed within nine months after the decedent’s death, although an extension of an additional six months is generally granted upon the filing of an application for extension [IRC §§6075 and 6081]. If the decedent died testate (i.e. with a valid Will in effect), the estate tax return must be accompanied by a certified copy of the Will.

When is Payment of the Estate Tax Due?

The estate tax must be paid at the time and place fixed for filing the estate tax return (determined without regard to any extension of time for filing the return). [IRC §6151(a)]. There are several statutes that permit deferral of payment of the estate tax [IRC §§6159, 6161, 6163 and 6166]. No discussion of these deferral statutes will be set forth here, except to state that the reasons for deferral of payment may be based on “reasonable cause”, “undue hardship”, or on a special provision for estate taxes attributable to certain interests in a closely-held business. [IRC §6166].

Inclusions in the Gross Estate

A decedent’s Gross Estate may include many different types of property interests. Property interests included in the Gross Estate are usually valued at fair market value on the date of death. There are special provisions, however, which allow for valuation on an alternate valuation date six months after the date of the decedent’s death [IRC §2032] or which allow for valuation based on a “qualified use” of real property for farming or related purposes. [IRC §2032A]. Some the special rules regarding the inclusion of property in a decedent’s Gross Estate are as follows:

  • Property Owned Outright This is the simplest and most obvious category of items included in the Gross Estate. Stated more precisely, the Gross Estate includes the value of all property to the extent of the decedent’s interest therein at the time of his death. [IRC §2033].

  • Statutorily Mandated Inclusion Since estate tax is a tax on the transmission of wealth at death, its scope extends beyond the taxing of only property owned outright at death. Certain other types of property are required to be included in the Gross Estate because, based on the judgment of the U.S. Congress, the decedent had sufficient use, control, enjoyment or power over the property to require that it be included in his Gross Estate. Some of the more common of these types of property interests are as follows:

    1. Near death transfers (IRC §2035).
    2. Transfers with retained lifetime enjoyment (§ 2036).
    3. Transfers taking effect at death or conditioned upon surviving the decedent (§ 2037).
    4. Revocable Transfers (§ 2038).
    5. Jointly-held property (§ 2040).
    6. Property over which the decedent held a general power of appointment (§ 2041).
    7. Life insurance policies on the decedent’s life over which the decedent retained certain incidents of ownership (§ 2042).

    A brief discussion of some of these items is set forth below:

  • Near Death Transfers: If the estate tax were to be exacted only upon assets actually owned at death, such taxes could easily be avoided by transfers made shortly before death. To protect against such avoidance, Congress initially treated as subject to estate tax the value of property transferred in contemplation of death. Under former Section 2035(a), any transfer made within three (3) years of a decedent’s death was considered to be made in contemplation of death.

    In 1981, Congress changed this rule by creating an integrated system of estate and gift taxes. This integrated system remains in effect today. Under this system, codified in IRC Section 2035(d)(2), property transferred within three (3) years of death will, with certain exceptions, escape inclusion in the decedent’s Gross Estate. That does not mean, however, that the transfer will escape from tax. The transfer will nonetheless be included in the final estate tax calculation so long as the transfer constitutes “an adjusted taxable gift”.

    There are certain instances where, fearing substantial tax avoidance would result, Congress maintained the three (3) year rule. This rule will apply to any interest in property transferred by the decedent within three (3) years of death that, had it been retained, would have been included in the decedent’s gross estate under Sections 2036, 2037, 2038 or 2042. Generally speaking, these sections apply to revocable transfers, transfers with a retained life estate, and transfers of life insurance policies on the decedent’s life.

    Aside from these special rules, all other taxable transfers made within three (3) years of death will not be part of the Gross Estate. Recall that such transfers will, as previously mentioned, become part of the estate tax calculation as “adjusted taxable gifts.” The amount that will become part of the calculation will be the value of the property at the time of the gift. Any appreciation in value between the date of the gift and the date of the decedent’s death will escape transfer taxes.

    There is an income tax cost to gifting property prior to death. Gifted property will retain a Section 1015 transferred tax basis (i.e., the same basis as in the hands of the donor) in the donee’s hands. The donee must, therefore, use that transferred for purposes of calculating his gain or loss on the sale or exchange of such property. On the other hand, if the property had been retained by the decedent until death and thus, included in the decedent’s Gross Estate, it would have received a Section 1014 fair market value basis. This can create a significant income tax disadvantage if the gifted property is highly appreciated.

    It should also be noted that any gift taxes paid by the decedent with respect to a gift within three (3) years of death will be brought back into the Gross Estate under Section 2035(c), even though the gift itself may not be part of the Gross Estate.

  • Transfers with Retained Interests As previously mentioned, the estate tax applies to many types of property interests beyond simple outright ownership. A decedent might choose to retain for his or her lifetime only certain attributes of ownership, such as the right to use or enjoy the property, the right to income from the property, or the right to designate who shall have the use, enjoyment or income from the property. This type of situation creates a policy dilemma; if a decedent transfers certain rights in property and yet retains other rights, what type of retained property interest should be taxed and what type should escape tax?

    The answers to these questions are contained in IRC§§ 2036-2038. A comprehensive examination of these sections is beyond the scope of the outline, however, a brief summary of each section follows: (i) under §2036, lifetime transfers of property are subject to estate taxation if the decedent kept for life either enjoyment or control over the property; (ii) under §2037, lifetime transfers of property are subject to estate tax where, even though the decedent has no current use, enjoyment or income rights, nor a right to control the use, enjoyment or income, the decedent has made the transferee’s possession or enjoyment of the property conditional upon surviving the decedent; and (iii) under §2038, lifetime transfers of property that may be revoked (such as a transfer to a revocable trust) are subject to estate tax.

  • Jointly-Held Property and the Estate Tax If joint property is held with rights of survivorship between husband and wife, then one-half of the value of such joint property is included in the Gross Estate of the first joint tenant to die and the other one-half is excluded from the Gross Estate. [IRC §2040(b)]. If joint property is held with right of survivorship between persons who are not husband and wife (such as parent-child or brother-sister), then the entire value of any joint property will be included in the estate of the first joint tenant to die, unless the estate can show by affirmative proof that the surviving joint tenant supplied some or all of the money used to purchase the joint property [§2040(a)].

  • Life Insurance The proceeds of any life insurance on the decedent’s life is included in his Gross Estate if: (i) the policy proceeds are payable directly or indirectly to the decedent’s estate; or (ii) the decedent held any incident of ownership in the policy, such as the right to change the beneficiary, surrender or cancel the policy or borrow against the policy. [§ 2042].

Deductions from the Gross Estate

Certain authorized deductions are permitted to reduce the amount of the Gross Estate. The figure determined by subtracting the authorized deductions from the Gross Estate is referred to as the “Taxable Estate”.

Some of the most commonly authorized deductions and a brief explanation of each of these deductions follows.

  • Expenses, Indebtedness and Taxes These items are generally deductible on the theory that the estate tax should apply only to the net amount of wealth transferred by a decedent at death. Claims against the estate obviously reduce the amount that a decedent transfers at death and hence, are generally allowed as a deduction. Under IRC §2053, there are four general categories of deductions permitted:

    1. funeral expenses
    2. administration expenses
    3. claims against the estate
    4. unpaid mortgages or debt on property the value of which is included in the Gross Estate
  • Funeral and administrative expenses Under IRC §2053, funeral and administrative expenses are generally deductible if they are actually paid and if they are considered proper claims against the estate under local law. Other types of claims against the estate are deductible only if they constitute a personal obligation of the decedent at the time of death. The deductibility of claims that are founded on a promise or agreement, even if they constitute a valid personal obligation of the decedent, are deductible from the Gross Estate only to the extent that they were contracted bona fide and for an adequate and full consideration (except for charitable contributions). Example: Prior to his death, decedent promises to pay each of his children $100,000.00. To evidence this promise, decedent executed a legally valid promissory note in favor of each child. Upon decedent’s death, will each child have a valid claim against the estate? If these notes constitute a deductible claim, then the estate tax would be very easily avoided. Under § 2053(c)(1)(A), however, each child’s deductible claim would be limited to the amount of consideration supplied by such child. Under these facts, the amount of the deductible claim would be zero.

Generally, deductions are allowed only to the extent they do not exceed the value of the decedent’s total property subject to claims as determined under local law (i.e., the probate estate). This reflects a policy decision to deny a deduction from the Gross Estate for expenses and claims of an insolvent probate estate. [IRC §2053(c)(2)] However, these obligations may be paid by the decedent’s heirs despite the fact that they are not legally obligated to do so. If this is the case, a deduction will be permitted, but only to the extent such obligations are actually paid prior to the due date for filing the estate tax return.

  • Losses Under §2054, a deduction from the Gross Estate is permitted for losses incurred during the settlement of the estate. Only certain types of losses (usually based on casualty or theft) are deductible under this section. Losses arising from fluctuations in market value between the date of the decedent’s death and the date of distribution do not give rise to a § 2054 deduction. The amount of the loss is generally equal to the difference in the value of the property immediately before the casualty and immediately after the casualty (adjusted for the amount of the insurance recovery, if any).

  • Transfers for Public Charitable and Religious Uses A deduction is allowed from the Gross Estate for equests to qualified recipient organizations. Unlike the income tax deduction, the estate tax charitable deduction is unlimited–so long as the detailed requirements of § 2055 are satisfied.

  • Bequest to Surviving Spouse An estate tax deduction, often referred to as the “unlimited marital deduction”, is allowed for the value of a qualified interest in property that passes at death from the decedent to his (or her) surviving spouse. This deduction reflects a basic Congressional policy; the estate tax is intended to be imposed on the transfer of wealth to younger generations (such as from a parent to child) and not on the transfer of wealth from one spouse to another. Thus, the government is content to wait for its money, exacting an estate tax upon the inevitable death of both spouses and not simply upon the death of the first spouse.

Marital Deduction Planning

Of the various deductions available against the estate tax, clearly the most significant is the unlimited marital deduction. There are two basic features of the unlimited marital deduction:

  • An Interest Must Pass to the Surviving Spouse A marital bequest must be to a legally recognized spouse. A bequest to a divorced or deceased spouse will not support a marital deduction. The surviving spouse must also be a citizen of the United States. If the surviving spouse is a non-citizen, the marital deduction is permitted onl if the interest passing to the spouse is placed in a special trust referred to as a “qualified domestic trust”. [IRC §2056A].

    The requirement that there be a “passing” does not means that the surviving spouse must receive his or her property interest by bequest. An interest is deemed to pass from a decedent to a surviving spouse if it passes by rights of survivorship, by the terms of a contract (such as an I.R.A. agreement or a life insurance policy), by the laws of descent and distribution or by the exercise of a power of appointment. [IRC §2056(c)].

  • The Interest Must be a Deductible Property Interest Mere passing of property from a decedent to a surviving spouse alone is not enough to support a deduction. An interest is deductible only to the extent such interest is included in determining the value of the Gross Estate. [IRC §2056(a)]. The reason for this rule is simple; if an item is not included in the Gross Estate, its passing should not support a deduction.

Marital Deduction Planning and the Terminable Interest Rule

A marital deduction will be disallowed if an otherwise qualified property interest is deemed to be a “terminable interest”. A “terminable interest” is an interest passing to a surviving spouse that will terminate or fail upon the occurrence of an event, the lapse of time or on the failure of an event or contingency to occur. A common example of a terminable interest is a devise of a life estate in real property from a decedent to a surviving spouse with a remainder interest to a child. Once again, the reason for this rule is simple; if a deduction is allowed from the Gross Estate of the first spouse, Congress wants to be certain that the same interest is taxed in the estate of the second spouse. In the situation where a surviving spouse receives only a life estate, nothing would be included in his or her Gross Estate because the interest would expire at death. Under the terminable interest rule, an interest in property passing to a surviving spouse will be non-deductible if: (i) the interest is terminable; (ii) the decedent has also given an interest in the property to another; and (iii) upon the termination or failure of the spouse’s interest, the other person may come into possession or enjoyment of the property. [§ 2056(b)(1)].

Marital Deduction Planning and the QTIP Election

The marital deduction requirements set forth above brought forth a number of complaints. Many people wanted their surviving spouse to enjoy their property but did not want the surviving spouse to have unlimited control over the property after their death. For example, why couldn’t a deceased husband leave his property to a surviving spouse in a trust, with the provision that the spouse receive all income for life (and a limited lifetime right to invade principal) and upon her death, the remainder disposed of according to his wishes and not hers?

The congressional response to this question was to create an exception to the terminable interest rule for “qualified terminable interest property”, commonly referred to by the acronym “QTIP”. Under IRC §2056(D)(7), if a proper QTIP election is made, no part of a terminable interest in property is treated as passing to anyone other than the surviving spouse, even though the surviving spouse has only a life interest and the remainder actually passes to others. A marital deduction will be allowed for the full value of the property for which a valid QTIP election has been made. The price tag of a QTIP election is that all QTIP property received by a surviving spouse will be subject to either gift tax (in the event of a lifetime transfer of the income interest by the surviving spouse) or estate tax (upon the surviving spouse’s death). [See § 2044 and § 2519].

There are two general requirements that must be met before a terminable property interest will be considered a qualifying interest. First, the surviving spouse must have a right to all of the income from the property for her life, payable annually or more frequently; and second, no one, including the surviving spouse, may have a power to appoint the property to anyone other than the surviving spouse during her lifetime. [§2056(b)(7)(B)]. Obviously, the purpose of these restrictions is to ensure that the value of the property not consumed by the surviving spouse will be a part of her estate tax at her death.

Credits Against the Estate Tax

A credit is a dollar-of-dollar reduction of the estate tax due. For this reason, a credit is more advantageous to the taxpayer than a deduction (which is not dollar-for-dollar). The more commonly applied credits against the estate tax are discussed below.

  • The Unified Credit Under the law in effect in 2009, only a taxable estate in excess of $3,500,000 is subject to federal estate tax.

  • Credit for State Death Taxes The credit previously allowed for state death taxes under IRC §2011 has been phased-out for decedents dying after December 31, 2004. Florida previously imposed a state death tax in the exact amount of the federal tax credit. This was known as a state “pick up” or “sponge” tax. Since the federal tax credit has been phased out, so too has Florida’s “sponge” tax. [See: Florida Statutes § 198.02].

  • Credit for Tax on Prior Transfers The purpose of this credit is to alleviate the estate tax hardship that could otherwise result from the death in quick succession of two or more persons. This credit is intended to alleviate some of that hardship by allowing a credit against the tax due on the second (or later) estate. A credit will be allowed for all or a part of the estate tax paid with respect to a transfer of property to the decedent by a person who died not more than 10 years before or two years after the death of the decedent. [IRC §2013].

  • Credit for Foreign Death Taxes The estate of a U.S. citizen may claim a credit against the federal estate tax for all or a part of the amount of death taxes actually paid to any foreign country with respect to property included in the decedent’s Gross Estate but situated in a foreign country. [IRC §2014].

The Generation Skipping Transfer Tax

Both the estate and gift tax apply to the gratuitous transfer of wealth to others by an owner of property. Neither tax considers the potential loss in revenue to the U.S. Treasury where an individual transfers wealth to a beneficiary who is more than one generation younger than the transferor. Stated simply, the problem is as follows: if at death, a decedent transfers wealth to his children, then the estate tax rules will apply to such transfer. In addition, when the children age and eventually die, the IRS will again seek to obtain tax revenues from the estate of the children. But, what if the decedent attempts to avoid a round of taxation by transferring wealth to his grandchildren instead of his children? How does the U.S. Treasury close this potential loophole? The answer is by use of the generation skipping transfer tax (the “GSTT”).

The GSTT applies to several different types of transfers to beneficiaries of lower generations. The first and simplest to understand is a direct transfers to certain persons who are two generations or more below the transferor (i.e. at least a grandchild) or who, if unrelated, are assigned to a generation two or more below that of the transferor. A direct transfer of that sort is called a “direct skip”. A GSTT can also apply to a “shifting of interests” in a trust such as would occur after upon the termination of a beneficiary’s life interest with a remainder interest to members of a younger generation. Example: grandfather puts $3.5 million in a trust which provides income to his children for life with a remainder to grandchildren. One child’s death, no amount will be included in child’s Gross Estate. The GSTT applies to this transfer (called a “taxable termination”) so as to close the tax loophole created when an interest in a trust avoids inclusion in the Gross Estate of certain beneficiaries and passed to succeeding generations estate tax free.

  • Basic GSTT Terminology An understanding of certain key terms is crucial to an understanding of the GSTT. The determination of a “transferor” is critical for GSTT purposes. The “transferor” is the individual who is deemed to have made a transfer of a property interest, generally the decedent (in the case of an estate tax) or the donor (in the case of a gift tax). Assignment of generation levels is also important; an individual’s generation level is generally determined with reference to the transferor. If the transferee is related to the transferor, the relationship determines the generational levels. If the transferee is unrelated to the transferor, the generation level is determined by the number of years separating the age of the transferee from that of the transferor. A “skip person” is an individual who is assigned to a generation two or more levels below that of the tansferor. A transfer is a GSTT transfer if all persons having an immediate right to receive income or corpus from the trust and all permissible non-charitable recipients of income and corpus are skip persons.

  • Three Types of Generation Skipping Transfers There are three types of generation skipping transfers: direct skips, taxable terminations and taxable distributions. Each is considered below:

    1. Direct Skips A direct skip is a transfer of an interest in property that is subject to either estate or gift tax and that is made to a skip person. Example: grandfather makes an outright gift of $100,000 to granddaughter. This is considered a direct skip because the $100,000 skips estate and gift taxation at the generation level of grandfather’s child. Congress deems it appropriate to impose the GST tax because of the fact that a generation has been skipped. Interestingly, however, a transfer to a great grandchild (or a descendant of an even younger generation) will still only be subject to a single GST tax.
    2. Taxable Terminations A taxable termination occurs only where a transfer has been made in trust. It occurs upon the termination of the entire interest of a beneficiary who has an immediate right to receive trust income or corpus and where immediately after such termination there are no non-skip persons having an interest in the trust. Example: grandfather creates a trust with income to child for life and with the remainder to grandchild. A taxable termination occurs upon the child’s death. The GST tax is imposed because the child’s interest in the trust terminates upon his death. The trust property then passes to the grandchild without imposition upon the child’s estate of any estate or gift tax.
    3. Taxable Distributions A distribution made from a trust to a skip person that is neither a direct skip nor a taxable termination is considered a taxable distribution. Example: grandfather creates a trust with income to child for life and remainder to grandchildren. The trustee has the power during child’s life to make distributions of principal to grandchildren. A taxable distribution occurs on the distribution of principal to grandchildren during child’s lifetime.
  • The Taxable Amount The GST tax (like most taxes) is determined by multiplying a tax base by the tax rate. The tax rate is a flat rate that is equal to the maximum federal estate tax rate (i.e. 45%). The tax base is usually the amount of the GST transfer — but the base amount can vary depending on whether a transfer is deemed to be a direct skip, a taxable termination or a taxable distribution. For example, the taxable amount of a direct skip is the value of the property received by the transferee. The tax imposed is referred to as “tax exclusive” because of this focus on what is received by the transferee after the payment of transfer taxes. Both taxable terminations and taxable distributions are deemed to be “tax inclusive”, meaning that the transferee is liable for the tax. If payment of the GST tax is made by the trust, that payment will be treated as a further distribution.
  • The Inclusion Ratio and the GST Exemption Each individual is entitled to a $3.5 million exemption from the GST tax (under the 2009 law currently in effect). The “inclusion ratio” is the mechanism by which the $1 million GST exemption allowed to each individual is allocated to a transfer. The inclusion ratio can be expressed as follows:

    Inclusion Ratio = GST exemption allocated to transfer / 1 – Value of the property transferred

    Example: In his will, grandfather bequeathed his entire $3.5 million estate to a trust with income to child for life, then income to grandchild for life and remainder to great grandchild. The personal representative of grandfather’s estate allocates his $3.5 million exemption to the trust. The inclusion ratio of the trust is zero. As a result, no GST tax will be imposed at child’s death or at grandchild’s death.