Estate Tax
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The federal estate tax is a tax on the privilege of transferring property at death. The estate tax taxes the value of property owned or passing at death, taking into account the value of property given away during life. For this year, i.e., the year 2010, the federal estate tax has been repealed. However, under current law, the estate tax will return in 2011 with rules that are similar to those that existed in 2001, before the Economic Growth and Tax Relief Reconciliation Act of 2001 was passed. This subchapter will be written as though the rules currently scheduled to take effect on January 1, 2011 have already taken effect. It should be noted, however, that there is great uncertainty in existence with regard to the estate tax. It is entirely possible that many aspects of this chapter will be altered or repealed prior to or some time after January 1, 2011. Rates When the estate tax returns in 2011, its rates will range from 41% to 55%. See I.R.C. § 2001. Unlike the gift tax, the estate tax is considered “tax inclusive” because the donee receives the bequeathed property, less the estate tax owed on it. For example: In 2011, Veronica dies and leaves a bequest of $174,000 to her daughter, Olive. If Olive had received the same amount as a gift during Veronica’s lifetime, only the amount in excess of the $13,000 exclusion amount would be considered a taxable gift. In addition, a $66,010 gift tax liability would have been paid by Veronica (41% of the $161,000 that is in excess of the $13,000 annual exclusion) if she had no more lifetime gift tax exclusion remaining. In contrast, since this is a bequest, the entire $174,000 would be liable for its share of the estate tax. In addition, since estate tax is measured tax inclusively, you have to measure what the 41% corresponds to in terms of the $174,000 total. This means that only $102,660 would actually go to Olive. Another example that illustrates the difference between inclusive measurement and exclusive measurement: Assume that the tax rate is 50%. If the tax is measured exclusively (as the gift tax and most other taxes are), a gift of $1,000,000 would incur a tax bill of $500,000. Thus, the donor would have to pay a total of $1,500,000 to give a gift of $1,000,000. However, if you count the tax as an inclusive percentage of the gift (as the estate tax is measured), the donor would have to give a gift of $2,000,000 to effectively allow the donee to keep $1,000,000. This is because the total bequest is what you look at to measure the 50% rate. Thus, a total gift of $2,000,000 is necessary to allow the donee to keep $1,000,000. As you can see, the inclusive system used in the estate tax system is much harsher than the exclusive system used for gift tax. In addition, making lifetime gifts is less expensive because the donee receives more and the donor simultaneously has a chance to reduce the size of the estate that will be taxed. Estate tax exemption amount (unified credit) Before the estate tax is imposed, an individual can transfer up to a certain amount of property at death without paying estate taxes. As of 2011, the lifetime estate tax exemption amount will be $1,000,000. This is accomplished via a unified tax credit that corresponds to the amount of tax on a $1,000,000 estate. For 2010, the unified credit amount is $345,800. This effectively eliminates estate tax on the first $1,000,000 in a person’s estate. In 2011, Veronica dies and leaves her entire net $1,000,000 estate to her daughter, Olive. Veronica made no taxable gifts during her lifetime. For 2011, the exemption amount is $1,000,000 and the unified credit is $345,800. If we use I.R.C. § 2001 rates to calculate the tentative tax on $1,000,000, the computation yields a $345,800 liability. In other words, the unified credit and the exemption amounts are opposite sides of the same coin. In contrast, for nonresidents who are not citizens of the U.S., the estate tax applies to that part of the decedent’s gross estate which is located in the United States with a minimal credit amount that is much lower than the credit allowed to citizens and residents. See I.R.C. § 2012. In addition to being taxed on much smaller estates, the procedures also differ; although the same range of tax rates apply to these nonresident aliens. See I.R.C. § 2101(b). For example: In 2011, Veronica (a Canadian citizen) dies and leaves her entire $1,000,000 estate of U.S. property to her daughter, Olive (also a Canadian citizen). Veronica made no taxable gifts during her lifetime. For 201, the exemption amount is $1,000,000 and the unified credit is $345,800. However, those amounts only apply to U.S. citizens. For nonresident aliens, the exemption amount is much less. As such, much of her estate will be subject to estate tax. The Marital Deduction and the Credit Shelter Trust As with the gift tax, transfers from one spouse to another, if both spouses are U.S. Citizens, are not subject to any estate taxation. There is an unlimited “marital deduction” for estate tax purposes. The “credit shelter trust” is a way for a husband and wife to avoid wasting the marital exemption, thereby minimizing estate taxes on the family unit. Specifically, when the first spouse dies, the other is normally entitled to an unlimited marital deduction, so the estate is not taxed. However, when the second spouse dies, there is no unlimited marital deduction available to shield the assets from estate tax. Rather, the estate only has the unified credit at its disposal. For example: In 2011, Adele and her husband, John, decide to investigate preparing an estate plan. They both have been very successful in their respective careers and have accumulated an estate valued at $4,000,000. Without planning, the surviving spouse will be entitled to an unlimited marital deduction, thereby avoiding estate taxes. However, when the second spouse dies, the combined $4,000,000 estate would be subject to estate taxes. Under a credit shelter trust planning scenario, after some of the property is allocated to a credit shelter trust (the amount allocated to the credit shelter trust will usually be the amount of the unified credit that the spouse has), the remaining property is paid to the surviving spouse or held in a marital trust (QTIP—discussed below) for his or her benefit. With a little planning, Adele and John from our previous example each can establish a credit shelter trust in the amount of the applicable exemption amount for whenever they die ($1,000,000 for 2011, etc.). When the first spouse dies, the exemption amount (say, $1,000,000) is paid to the credit shelter trust. That amount is absorbed by the unified credit and thus passes free of estate tax. The remaining $3,000,000 passes as part of the unlimited marital deduction, thereby avoiding estate taxes. When the second spouse dies, the taxable estate is only $3,000,000 instead of $4,000,000. Step-up in basis As previously discussed, property acquired from a decedent receives a step up in basis equal to the fair market value of the property at the decedent’s death (or alternate valuation date within six months of death). For example: John bought 1,000 shares of Microsoft stock in 1981 for $10,000. After all the splits and appreciation, that stock is worth $2,500,000 in 2009. If John were to sell that stock, he would have to pay capital gains tax because he realized a gain of $2,490,000. If John gave the stock to Cindy as a gift in 2009, Cindy would take John’s original ($10,000) basis. Thus, when Cindy sells the stock, she will be liable for a big capital gains tax bill. However, if John dies in 2009 and left the stock to Cindy, then Cindy will get a “step-up” in basis so that the new basis will be equal to the date of death value of the stock. Thus, Cindy’s basis will be $2,500,000. Thus, if she sells the stock for $2,500,000, she will not have realized a capital gain at all and will not be liable for capital gains tax. This example illustrates how important in saving taxes the step-up in basis can be. It is important to note that, for the year 2010, the step-up in basis rule is quite different than it will be as of January 1, 2011. During this year, the step-up in basis rule is allowable only to citizens of the United States and is limited to $1,300,000 in appreciated assets. For non-citizens, the step-up in basis will be limited to only $60,000 in appreciated assets. See I.R.C. § 1022. Marital deduction (QTIP and QDOT) Like under the gift tax system, an unlimited deduction from the gross estate of a decedent is allowable for the value of property that passes to a surviving spouse who is a citizen. See I.R.C. § 2056. In order to qualify for the marital deduction, property must “pass” from the decedent to the surviving spouse either outright or in another qualifying manner. Permissible methods include:
Generally, terminable interests given to a surviving spouse do not qualify for the marital deduction. A “terminable interest” in property is an interest that will terminate or fail on the lapse of a certain period of time, or on the occurrence of some contingency or its failure to occur. (This concept compares to a donor having to give up complete “dominion and control” of property before a transfer is considered a gift.) Thus, life estates (someone has use of property or income during his or her life; the corpus or principal passes to someone else at death) and estates for terms of years (someone has use of property or income for a limited number of years before the corpus or principal passes to someone else) are terminable interests. Therefore, a transfer of an interest into a trust for the spouse will generally not qualify for the marital deduction. However, I.R.C. § 2056 and the accompanying regulations contain several exceptions to this general rule. Basically, they provide ways for transfers to surviving spouses to qualify for the marital deduction, if they meet certain conditions. Two common ones are: 1) a life estate with a general power of appointment in the surviving spouse (a power that gives the spouse the authority to determine what happens to the money at or before her death); and As with the gift tax, there are also certain modifications of the marital deduction for surviving spouses who are not U.S. citizens. Specifically, the marital deduction is denied for federal estate tax purposes for property passing from a citizen spouse to an alien spouse. See I.R.C. § 2056(d)(1). Nevertheless, a marital deduction is allowed for property passing at death to an alien spouse via a qualified domestic trust (“QDOT”). See I.R.C. § 2056(d)(2)(A). Section 2056 sets forth a series of comprehensive rules that trusts must meet to qualify as a QTIP and/or a QDOT. Charitable deduction Similar to under the gift tax, an unlimited deduction may be taken for the value of property (reduced by any expenses or taxes payable from such property) included in the decedent’s gross estate that is transferred in a qualifying manner for public, religious, charitable, scientific, literary or educational uses. See I.R.C. § 2055. Expenses In determining the taxable estate, certain expenses are permitted as deductions, including:
See I.R.C. §§ 2053(a)(1)-(a)(3), 2054, respectively. State Transfer Taxes Many states impose their own estate taxes on deceased citizens of their states and on people who own property within the state when they die. When the estate tax returns in 2011, a credit against the federal estate tax will be allowed against the federal estate tax for any type of estate or inheritance tax actually paid to any U.S. state or territory. See I.R.C. § 2011(a). The maximum allowable amount for this credit is determined by using the state death tax credit table. See I.R.C. § 2011(b)(1). Because of this limitation, many states simply assess an estate tax that is equal to the maximum credit that is allowed against the federal estate tax. In other words, the federal and state systems were historically coordinated so that most states imposed their own estate tax only insofar as that amount could be deducted from federal estate tax liability, resulting in no additional tax being paid as a result of the state estate tax. However, when the estate tax exemption amount was raised dramatically in 2001, many states “decoupled” their estate tax from the federal estate tax; passing rules that imposed state estate taxes even on amounts lower than the federal exemption. This resulted in state estate tax on estates that were not subject to federal estate tax. These states generally continue to impose estate tax in 2010, even though there is no federal estate tax. For example, New Jersey, as is typical of most states, has historically imposed what is called a “pick-up” estate tax: a state tax that equaled the maximum available federal credit against state estate taxes. So, there was traditionally no additional tax that was actually paid by the estate. New Jersey simply split the total estate tax revenue with the federal government. However, New Jersey froze its credit at the level the federal government used prior to 2000; i.e., at $675,000. Accordingly, since the two systems are no longer in sync with each other, New Jersey estates of more than $675,000 will state estate taxes even though they are not subject to the federal estate tax. |
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