Estate and Gift Taxes(redirected from Testamentary Transfers)
Estate and Gift Taxes
A combined federal tax on transfers by gift or death.
When property interests are given away during life or at death, taxes are imposed on the transfer. These taxes, known as estate and gift taxes, apply to the total transfers that an individual may make over a lifetime.
Estate and gift tax law is primarily statutory. Although the Treasury Department issues regulations governing the interpretation of the revenue laws, and although state and federal courts contribute their interpretations of statutory law, the foundation of the transfer taxes rests in chapters 11 and 12 of the Internal Revenue Code. To understand the complex statutory framework requires a basic understanding of the concepts underlying the estate and gift tax system. The transfer tax laws apply to all gratuitous shifts in property interests. But although administered similarly, the estate tax and gift tax have somewhat different goals. The gift tax reaches the gratuitous Abandonment of ownership or control in favor of another person during life, whereas the estate tax extends to transfers that take place at death, or before death, as substitutes for dispositions at death. Both taxes are intended to limit the concentration of familial or dynastic wealth.
Estate and gift taxes became a source of political debate in the late 1990s, as many members of Congress pressed for an end to these taxes. They argued that such "death taxes" were unfair and forced small businesses and family farmers to sell off their assets to pay the estate taxes. Opponents of repeal noted that even though the potential tax rate was quite high, at 55 percent, most individuals never paid any estate or gift tax. Under the tax system that had been in place since 1986, every person could transfer a combined $600,000 worth of property during life and at death without paying tax. This tax-free allowance corresponded to $192,800 worth of federal tax savings and is known as the "unified credit against estate tax." This unified credit was sufficient to satisfy taxes on transfers by all but the richest five percent of U.S. citizens. Defenders of estate and gift taxes maintained that these taxes were guided by an important government and social policy: the prevention of large concentrations of dynastic wealth. Moreover, they pointed out that estate tax collections typically constitute less than two percent of total Internal Revenue Service collections.
The debate on this issue culminated in the Economic Growth and Tax Relief Reconciliation Act of 2001. The top estate tax rate was reduced from 55 percent to 50 percent in 2002 (together with the repeal of the 5 percent surtax on estates over $10 million), 49 percent in 2003, 48 percent in 2004, 47 percent in 2005, 46 percent in 2006, and to 45 percent in years 2007 through 2009. The credit-level exemption was raised from $675,000 to $1 million in 2002, $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009. Most importantly, the estate tax was to be repealed in 2010. However, the law contains a "sunset" provision. If Congress does not extend the law beyond 2010, the new law will end on December 31, 2010, and the previous estate law will be in effect again. Since the political landscape undoubtedly will have changed, it is impossible to predict what will happen to the estate tax.
The gift tax was not repealed, but it was modified. The new law increases the total gift tax exemption from $675,000 in 2001 to $1,000,000 in 2002 and thereafter. After 2009, the gift tax is retained at the top Income Tax rate for the applicable year, which is currently 35 percent. The retention of the gift tax is meant to discourage transfers to lower income beneficiaries to minimize capital gains taxes.
With few exceptions, the individual making the transfer is responsible for any transfer tax owed (whereas, in contrast, the individual receiving income is responsible for any income tax owed). Thus, the executor of an estate, as the estate's representative, is responsible for paying any estate tax due, and the donor of a gift is responsible for paying any gift tax due.
The Internal Revenue Code defines a gift as a "transfer … in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible." Generally, a gift is any completed transfer of an interest in property to the extent that the donor has not received something of value in return, with the exception of a transfer that results from an ordinary business transaction or the discharge of legal obligations, such as the obligation to support minor children. This definition of gifts does not require the intent to make a gift. An individual may make gifts of both present interests (such as life estates) and future interests (such as remainders) in property (26 U.S.C.A. § 2503(b)).
From a tax standpoint, gifts have two principal advantages over transfers at death. First, gifts allow a donor to transfer property while its value is low, allowing future appreciation in property value to pass to others free of additional gift or estate tax. Second, provided that the gift is of a present interest in property, a donor may transfer up to $11,000 exempt from tax to each donee every calendar year, which allows the donor to reduce the size of the estate remaining at death without any transfer tax consequences.
To constitute a gift, a transfer must satisfy two basic requirements: It must lack consideration, in whole or in part (that is, the recipient must give up nothing in return); and the donor must relinquish all control over the transferred interest. To constitute a tax-exempt gift, a transfer also must constitute a present interest in property. (A present interest is something that a person owns at the present time, whereas a future interest is something that a person will come to own in the future, such as the proceeds of a trust.)
Lack of Consideration A transfer is not a gift if the transferor receives consideration, or something of value, in return for it. For example, if A sells B a used car worth $5,000 and receives $5,000 in exchange, the transfer is not a gift because it is supported by "adequate and full consideration" (26 U.S.C.A. § 2512(b)). But if A sells B the same car for only $2,000, the transfer constitutes a gift of $3,000 because A exchanges $3,000 worth of car for nothing. Finally, if A gives B the car without receiving anything in return, the transfer constitutes a gift of $5,000. Although consideration may be whole or partial, not all transfers for partial or insufficient consideration result in gifts. An arm's-length sale—that is, a sale free of any special relationship between buyer and seller—will not be considered a gift where no intent to make a gift exists, even if the consideration is not adequate. This limit on the definition of gifts excludes bad business deals and forced sales from gift tax treatment.
The Completeness Requirement A transfer constitutes a gift for tax purposes only if the donor has parted with the ability to exercise "dominion and control" over the property transferred. Many transfers of property satisfy this condition. For example, if A takes B out for a birthday dinner, the act of purchasing the dinner is a gift because A cannot regain control over the food that B consumes, or revoke the acts of purchasing and consuming the meal. When the donor has not relinquished absolutely the ability to control or manage the property or its use, however, the "gift" may not be complete for tax purposes. The most common example of an incomplete transfer is a transfer of property to a revocable trust, in which the donor retains the right, as trustee, to alter, amend, or rescind the trust. The gift is not completed because the donor could restore ownership in the trust property to himself or herself, or change his or her mind about who will enjoy or later receive the property.
This distinction between complete and incomplete transfers determines whether property will be included in an estate at death, as well as the value of that property. The value of property that was incompletely transferred during life will be included in the gross estate at death (26 U.S.C.A. §§ 2035–2038). Therefore, any appreciation in the value of incompletely transferred property will be included and taxed in the estate, whereas none of the value of completely transferred property will be included in the estate. Accordingly, if A transfers 1,000 shares of XYZ stock outright to B when it is worth $10 per share, the value of the transfer subject to tax equals zero because A can take advantage of the annual exclusion described in the following section. If A transfers the same stock to a revocable trust for B's benefit, however, and that stock is worth $100 per share on the date of A's death, the entire $100,000 is included and taxable in A's estate. Moreover, any income distributions from the trust after the transfer of property to the revocable trust are taxable gifts to B for which A must pay tax.
Sometimes people make incomplete transfers, rather than completed gifts, in order to retain control over the property, even though appreciation in property value is taxed as a consequence of an incomplete transfer. For various reasons, a person might not want to give up that control. An individual might wish to control the distribution of income from a gift to a trust, or even to receive the income distributions from a trust. Or an individual may create a trust for non-gift reasons, such as to ensure property or investment management. Parents might not trust their children to manage gifts of stock or cash effectively, and thus might retain control to ensure that transfers are not squandered. Occasionally, donors mistakenly believe that revocable trusts are effective devices to avoid paying estate taxes, and simply do not realize that transfers to revocable trusts are incomplete for gift purposes.
Present versus Future Interests: The Annual Exclusion Each individual may make taxexempt gifts of up to $11,000 to each donee every year. To qualify for this so-called annual exclusion, a gift must be of a present interest in property (26 U.S.C.A. § 2503(b)). Completed transfers of future interests, such as remainder interests in real estate or the vested right to the distribution of trust principal on the donor's death, constitute gifts for tax purposes but do not qualify for the annual exclusion.
Only the unrestricted right to use, enjoy, or possess property in whole or in part constitutes a present interest. For example, if A transfers a life estate in his home to B, with a remainder to C, only the life estate to B, which is a present interest in the home, qualifies for the annual exclusion. The remainder interest to C is a completed gift, but does not qualify for the annual exclusion because it is a gift of a future interest. A more subtle and common illustration of this principle involves trust property. For example, A creates an irrevocable trust giving B, the trustee, complete discretion over the distribution of income to C for ten years, at which time the trust will terminate and the entire trust corpus and accumulated income will be paid to C. In this case, A has made a completed gift of the entire trust corpus, but the gift does not qualify for the annual exclusion because C has no present right to the trust income.
The gross estate is the measure of the interests an individual is considered capable of transferring at the time of death, and provides the starting point for computing the estate tax (26 U.S.C.A. § 2031). The gross estate is an artificial concept, in part because it may include interests that the individual did not actually own at death (§§ 2035–2038). From the gross estate are deducted expenses of administering the estate, the decedent's legal obligations at death, the value of property passing to a surviving spouse, and the value of bequests to charity (§§ 2053–2056). The remainder is known as the taxable estate and is the value on which the estate tax is computed.
Conventional interests in property, such as ownership of real estate, stocks and bonds, cash, automobiles, art, and Personal Property, must be included in the gross estate and valued at their fair market value on the date of death. In addition, interests in life insurance, annuities, and certain death benefits are included to the extent that the decedent was able to confer an interest in them on another person. Finally, three somewhat artificial ownership attributes, including the power to change beneficial enjoyment and the power to revoke or change the type and time of enjoyment, are included in the gross estate to the full extent of the property to which the power applies. The value of property included in the gross estate is equal to its fair market value on the date of death.
Designation of Beneficiaries Life insurance, annuities, and certain death benefits are substitutes for dispositions at death, and are included in the gross estate to the extent that the decedent owned or could exercise "incidents of ownership" over them until the time of death. Thus, the value of a life insurance policy payable to the decedent's estate on death is included in the decedent's gross estate (26 U.S.C.A. § 2042(a)(1)). In addition, life insurance is includable in the gross estate even though neither the decedent nor the decedent's estate actually owned it, if the decedent possessed any incidents of ownership over the policy. Incidents of ownership encompass the rights to change the distribution of the economic benefit flowing from the insurance policy. For example, if A purchases a life insurance policy that is payable to B on A's death, the value of that policy is includable in A's gross estate if she retained, at the time of her death, the ability to change the policy beneficiary to C. If the decedent had no rights to direct or affect economic benefits at the time of her death, then the proceeds of the policy are not includable in the gross estate.
Powers of Appointment Frequently, an individual owns the power to designate who will enjoy an item of property. This power may be considered an attribute of ownership sufficient to be included in the gross estate. The provision 26 U.S.C.A. § 2038, discussed later under retained power, addresses these powers of appointment that individuals reserve to themselves when creating property rights for another individual. Section 2041, in contrast, includes in the gross estate the value of property subject to a "general" power of appointment that the decedent acquired from another person. A general power of appointment is one that individuals may exercise in their own favor or in favor of their estate, their creditors, or the creditors of their estate. If the decedent may only exercise the power in conjunction with either the creator of the power or a person having an adverse interest in the property subject to the exercise of the power, then the power is not considered a general power of appointment because the decedent cannot freely control the transfer of the property at the decedent's death, and the property subject to the power is not included in the gross estate. For example, if A dies and leaves B the right to income in a trust, as well as the right to appoint the trust in whatever manner he wishes, then the entire value of the trust is included in B's estate when B dies. If, by contrast, A leaves B the right to income from the trust as well as the right to appoint the trust only to C or C's heirs, then no portion of the trust is includable in B's estate when B dies.
A power that is limited by an ascertainable standard is not a general power, even if it otherwise appears to be a general power. Ascertainable standards include health, education, support, and maintenance. Accordingly, if A dies and leaves B the power to appoint trust principal to herself if it is required for her health, education, support, or maintenance, B's power is limited by an ascertainable standard, and the value of the trust is not included in the gross estate. But if B may invade the trust principal for her "comfort and happiness," B's power is not limited by an ascertainable standard, and the value of the trust is included in B's estate.
Artificial Aspects of the Estate Tax System Before 1976, the gross estate included the value of all gifts made in contemplation of death. Because determining whether a gift was in contemplation of death turned out to be subjective, difficult to prove, and somewhat morbid, a 1976 amendment to the estate tax law automatically included any gift that a decedent made within three years of death (26 U.S.C.A. § 2035(a)). Unfortunately, the effect of § 2035(a) was to include in the gross estate the full value of the transferred property at the date of death, including any appreciation in value since the transfer. Thus, if A transferred $3,000 worth of stock to B in 1978 and died in 1980, when the stock was worth $25,000, the stock's full value of $25,000 was included in the gross estate, defeating much of A's pre-death tax planning.
In 1981, sweeping tax changes eliminated from the gross estate most transfers made within three years of death. Even so, three specific types of transfers—transfers with a retained life estate, transfers with retained powers, and transfers effective on death—are included in the gross estate because the decedent owned an interest in the property at the time of death. Moreover, the value of property once subject to certain retained interests is included in the gross estate if the release or lapse of the retained interest takes place within three years of death, because the disposition of the retained interest is considered a substitute for disposition at death.
Transfers with a retained life estate Transfers with a retained life estate are covered in 26 U.S.C.A. § 2036. For purposes of the estate tax laws, the term life estate includes more than just an expressly retained life interest in property. For example, if A creates a trust for the benefit of B but retains the right to receive the income from the trust for the rest of her life, her retained income interest clearly is a retained life estate in the property. But the retention of the right to change the economic benefit derived from the property also constitutes a retained life estate, as when A reserves the right to change the trustee and appoint herself the trustee. It also might include retained life estates by tacit agreement, such as when A transfers her home to B, with the understanding that A and not B will live there for the rest of her life.
The mere possession of a life estate in property is insufficient to bring it into the gross estate under § 2036. The life interest must be retained by the decedent and must apply to an interest in property that the decedent transferred. Thus, a life income interest created by someone other than the decedent is not includable in the gross estate under § 2036.
Transfers with retained powers Transfers in which the decedent owns, at the time of death, the power to alter, amend, revoke, or terminate the enjoyment of the property are covered in 26 U.S.C.A. § 2038(a)(1). In contrast to § 2041, which allows general powers of appointment, § 2038 includes only powers associated with a property interest that the decedent gave away during his or her lifetime. The most commonly encountered retained powers are the powers applicable to a revocable trust. A revocable trust is a legal instrument through which an individual relinquishes legal ownership over the property to the trustee of a trust, either retaining to himself or herself beneficial enjoyment of the property, such as the right to income, or granting it to another individual. As its name indicates, the revocable trust is set up so that the creator, known as the grantor, the settlor, or the trustor, may revoke the trust entirely, may change the terms of the trust, or may change the beneficial ownership in the trust.
The creation of, or an addition to, a revocable trust almost never constitutes a gift. A gift must be completed in order to be taxable; the creation of or an addition of property to a revocable trust is, by definition, incomplete because the creator may change the beneficial enjoyment at some time, effectively withdrawing the "gift." Distributions from a revocable trust may, however, constitute completed gifts. For example, if A transfers $2 million to a revocable trust that pays income to B, the transfer of the $2 million is not a completed gift, but the annual payment of $100,000 in interest to B is a taxable gift when it takes place. Upon A's death, the entire value of the property subject to the power, including both the trust corpus and undistributed income payable to B, is included in the gross estate. And, because the property is valued as of the date of death, any increases or decreases in the value of the property since the transfer will appear in the gross estate.
Transfers effective on death The provision 26 U.S.C.A. § 2037 includes in the gross estate the value of transfers that take effect on death. Although at a distance § 2037 seems to apply to all property transfers that occur as a result of an individual's death, the stipulated transfers are rarely encountered. To meet the requirements of § 2037, the beneficiary must be able to acquire an interest in the property only by surviving the decedent. Furthermore, the decedent must have expressly retained a reversionary interest in the property that is worth at least five percent of the property's value at the time of death. Both conditions are difficult to meet. In the first place, the requirement that the beneficiary obtain an interest in the property solely by surviving the decedent is exclusive: If the beneficiary could have obtained an interest in any other way, such as by surviving another individual, satisfying a condition, or outlasting a term of years, the property is not includable under § 2037. In the second place, the requirement that the decedent's retained reversionary interest exceed five percent of the property's value is difficult to satisfy because most retained reversions represent remote interests that reach fruition only if the primary, secondary, and all contingent beneficiaries die first or fail to satisfy the conditions of ownership.
Release or lapse of rights The gratuitous relinquishment or lapse, within three years of death, of a retained life estate under 26 U.S.C.A. § 2036, a retained reversion under § 2037, a retained power under § 2038, or an interest in life insurance under § 2042 will subject the value of the property, subject to the retained interest, to inclusion in the gross estate. This result is a remnant of the pre-1981 policy that transfers "in contemplation of death" should be included in the gross estate. Under § 2035(d)(2), the release or relinquishment of a retained interest within three years of death is conclusively presumed to be "in contemplation of death." Thus, if A transfers his home to B in 1985, retaining the right to live there for life, but abandons that right at the end of 1991, a gift of the remainder interest in the property takes place in 1985, followed by a gift of the relinquished life estate in 1991. But if A dies before the end of 1994, both the 1985 and 1991 gift tax returns will be ignored for estate tax purposes, and the entire value of the home will be included in A's gross estate.
As with the retained life estate, the relinquishment or release within three years of death of a power of appointment retained under § 2038 will cause inclusion of the full value of the property at its date-of-death value. For example, if A creates a revocable trust in 1982, then amends it to make it irrevocable at the end of 1992, a gift will result in 1992 when the trust becomes irrevocable. If A dies before the end of 1995, the entire value of the trust, including any appreciation in value, will be included in A's estate, and the 1992 gift will be ignored. Finally, the release or lapse of ownership or any incidents of ownership over a life insurance policy will cause the entire value of that policy to be included in the gross estate.
Once the value of the gross estate has been computed, the estate is entitled to take deductions. Expenses associated with administering the estate, such as funeral expenses, executors' commissions, and attorneys' fees, as well as debts the decedent owed at death, are deductible because they necessarily reduce the value of the property that the decedent actually is capable of transferring (26 U.S.C.A. § 2053(a), (b)). The two most important deductions for tax purposes are the marital deduction and the charitable deduction.
The Marital Deduction The marital deduction applies to certain interests in property passing from the first spouse to die, to the surviving spouse. It permits an estate to deduct the value of certain property included in the estate from the value of the gross estate, thus eliminating the estate tax with respect to that property. The rationale behind the marital deduction is simple: that a husband and a wife should be considered a single unit for purposes of wealth transfer. Accordingly, as a general rule, the marital deduction will be allowed with respect to certain property passing to a surviving spouse, provided that it will be included and taxed in the estate of that spouse on his or her death.
To qualify for the marital deduction, property must satisfy three basic requirements. First, the surviving spouse must be a U.S. citizen. Second, the interest in the property must pass directly from the first spouse to die, to the surviving spouse. Third, the interest generally must not be terminable (26 U.S.C.A. § 2056). The concept of a terminable interest is complex and technical, but for the most part, an interest is terminable for tax purposes if another interest in the same property passes to someone other than the surviving spouse by reason of the decedent's death, allowing that other person to enjoy the property after the surviving spouse's interest terminates. For example, if A leaves to her husband, B, a life estate in her property, with a remainder to their children, her bequest to B does not qualify for the marital deduction. B's interest terminates automatically on his death, and the children, by reason of the termination, will then enjoy the property.
If no one else can enjoy the property following the termination of the surviving spouse's interest, the property interest is not considered terminable for tax purposes, and a deduction will be allowed. For example, if A leaves to her husband, B, her interest in a patent, and dies while the patent has ten years of life left, the patent interest qualifies for the marital deduction, because no one else will enjoy it after it expires.
Whether an interest is terminable must be determined at the time of death. Therefore, even if an event following the first spouse's death makes the termination of the surviving spouse's interest impossible, the marital deduction will not be allowed if it technically was terminable at the time of death.
Congress in 1981 created an important exception to the general rule that a terminable interest does not qualify for the marital deduction. This exception, called the qualified terminable interest property (QTIP) exception, is a sophisticated statutory rule allowing the estate to deduct the value of a terminable interest that passes to the surviving spouse as long as the transfer meets five requirements:
- the surviving spouse receives all or a specific portion of the income for life from the interest
- the income from the QTIP … is paid at least annually
- the surviving spouse has the power to appoint the interest to himself or his estate
- the power must be exercisable in all events
- no other person has the power to appoint the interest to anyone other than the surviving spouse (26 U.S.C.A. § 2056(b)(7)) In return for the marital deduction, the estate must agree that the QTIP will be included in the estate of the surviving spouse at death, to the extent that the surviving spouse has not disposed of the property during his or her life (§ 2044).
The Charitable Deduction The charitable deduction permits an estate to deduct the entire value of bequests to any of a number of public purposes, including the following:
- any corporation or association organized for religious, charitable, scientific, literary, or educational purposes
- the United States
- a state or its political subdivisions, and the District of Columbia
- a foreign government, if the bequest is to be used for charitable purposes
- selected amateur sports organizations (26 U.S.C.A. § 2055(a)).
The charitable deduction is intended to provide wealthy individuals a tax incentive to benefit the public interest. Only bequests passing directly from the decedent's estate to the charitable entity qualify for the deduction. Therefore, if A leaves $100,000 to her son C, who gives $50,000 to the Red Cross immediately after A's death, A's estate cannot receive a charitable deduction for the sum given to the charity (§ 2518(b)(4)).
Computation of Tax
The estate and gift taxes are progressive and unified taxes, meaning that each taxable transfer taking place after 1976 is taken into consideration when computing the tax on subsequent transfers. For example, if A makes a taxable gift of $500,000 in 1990, the marginal tax rate on the gift is 34 percent. If A makes another taxable gift of $200,000 in 1992, the tax is computed on $700,000, the sum of the post-1976 gifts. Because the first $600,000 of transfers during life and at death are tax free, a unified credit of $192,800 is deducted from the tax on A's 1992 gift. If A dies in 1995 leaving an estate worth $2 million, the tax is computed on $2.7 million, the sum of the value of the estate and the lifetime gifts; the value of the unified credit and the taxes actually paid on the 1992 gift are deducted.
Progressivity in the estate and gift tax system ensures that individuals cannot avoid increased tax rates by making a series of small transfers. If the taxes were not progressive, then $1 million parceled out into ten annual gifts of $100,000 would be taxed at the marginal rate of 26 percent for each gift, whereas under the progressive tax system, the gifts are taxed at the marginal rate of 39 percent. Similarly, unification between the transfer tax systems ensures that individuals cannot avoid paying higher estate tax rates at death simply by giving away most of their property interests during life. Thus, in the case of A above, the marginal tax rate on A's estate is 49 percent, computed on $2.7 million of total lifetime and death transfers, rather than 45 percent, computed only on the value of the gross estate.
Barlett, Bruce. 2003. "Taxing Debate: The Estate Tax." National Review (January 23).
Economic Growth and Tax Relief Reconciliation Act of 2001, H.R. 1836, May 25, 2001.
"The Revocable Living Trust as an Estate Planning Tool." 1972. Real Property, Probate, and Trust Journal 11.Stephens, Richard B., et al., eds. 2002. Federal Estate and Gift Taxation. 8th ed. Valhalla, N.Y.: Warren Gorham & Lamont.