Applicable exemption (exclusion) amount:
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.
There was a lot of political wrangling leading up to January 1, 2013 regarding the estate tax, as part of the “fiscal cliff” that was threatened if the Bush tax cuts were allowed to expire. While Democrats, including the President, were pushing for the estate tax to be kept, Republicans have been pushing for a long time for the estate tax to be repealed.
In December of 2012, Congress and President Obama agreed on a deal that would allow the estate tax to remain in effect. However, the exemption amount for each person was raised to $5,000,000 (from $3,500,000 in 2012 and much less in previous times). This figure is also adjusted for inflation and so it is scheduled to rise every year. In 2017, the amount is $5,490,000. In addition, the maximum estate tax rate was reduced to 35%, from as high as 60% prior to the Bush tax cuts in 2001.
The maximum estate tax rate is now 35%. 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. Therefore, the tax can be harsher than the gift tax, even though applied at the same rates. For example:
In 2017, Veronica gifts $214,000 to her daughter, Olive. Assuming Olive had no gift tax exemption remaining, only the amount in excess of the $14,000 exclusion amount would be considered a taxable gift. In addition, if Veronica has met or exceeded her lifetime unified credit, then a $70,000 gift tax liability would be paid by Veronica (35% of the $200,000 that is in excess of the $14,000 annual exclusion). In essence, Veronica may paying $284,000 to give Olive $214,000.
In contrast, if Veronica dies with no exemption remaining and left $284,000 for Olive, 35% of that amount goes to pay estate tax. 35% of $284,000 is $99,400. This leaves only $184,600 for Olive. Though both taxes were applied at 35%, the gift tax would cost Olive $29,400 less than the estate tax on the same amount.
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 inclusive 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. The lifetime estate tax exemption amount was $5,000,000 as of 2011 and then was adjusted for inflation each year. For 2012, the amount was $5,120,000. The amount for 2013 is $5,250,000. As of 2017, the amount is $5,490,000. For the sake of simplicity, we will assume a $5,000,000 exemption, though please keep in mind that this amount will be adjusted each year for inflation.
This is accomplished via a unified tax credit that corresponds to the amount of tax on a $5,000,000 estate. For a $5,000,000 estate, tax amount would be $1,730,800 under estate tax rates. Therefore, each estate would get a tax credit of $1,730,800 to be applied against estate taxes.
In 2011, Veronica died and left her entire net $5,000,000 estate to her daughter, Olive. Veronica made no taxable gifts during her lifetime. For decedents dying in 2011, the exemption amount was $5,000,000 and the unified credit is $1,730,800. If we use the estate tax rates to calculate the tentative tax on $5,000,000, the computation yields a $1,730,800 liability. Since the unified credit is $1,730,800, the estate would pay no estate tax. In other words, the unified credit and the exemption amounts are opposite sides of the same coin. A $5,000,000 exemption is the same as a $1,730,800 unified credit.
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 applies to these nonresident aliens. See I.R.C. § 2101(b). For example:
In 2011, Veronica (a Canadian citizen) died and left her entire $5,000,000 estate of U.S. property to her daughter, Olive (also a Canadian citizen). Veronica made no taxable gifts during her lifetime. For 2011, the exemption amount was $1,000,000 and the unified credit was $1,730,800. 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 $5,000,000. 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 $5,000,000 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 ($5,000,000 for 2011, etc.). When the first spouse dies, the exemption amount (say, $5,000,000) is paid to the credit shelter trust. That amount is absorbed by the unified credit and thus passes free of estate tax. The remaining $5,000,000 passes as part of the unlimited marital deduction, thereby avoiding estate taxes. When the second spouse dies, the taxable estate is only $5,000,000 instead of $10,000,000.
However, it is important to note that under the law in effect as of January 1, 2013, the credit shelter trust device has been rendered unnecessary in many cases. This is because the law now allows “portability” of estate tax exemption. This means that if one spouse dies without using up his or her federal estate tax exemption, the unused portion may be transferred to the surviving spouse if elected by the executor of the estate of the first-to-die spouse. We are keeping the section on credit shelter trusts in the courseware because it is a standard, known device in the industry and because it still can be relevant to certain types of trusts. But please note that in many cases, portability has rendered the credit shelter trust device unnecessary.
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 2013, 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.
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:
- passing by will or through intestacy;
- passing property to a spouse who is a joint tenant with right of survivorship;
- exercising the decedent’s general power of appointment in the decedent;
- property devolved upon a surviving spouse as a result of his or her dower or curtesy interest or statutory interest; or
- property passed as a result of a beneficiary designation (e.g., life insurance policy or pension interest). See
Treas. Reg. § 20-2056(c)-1-2.
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:
- 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
- A qualified terminable interest in property (“QTIP”). This is typically a trust that gives all of its income to the spouse during his or her life and contains some other formalities that are beyond the scope of this discussion.
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.
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.
In determining the taxable estate, certain expenses are permitted as deductions, including:
- funeral expenses,
- administrative expenses (commonly, commissions paid to personal representatives, court costs and reasonable legal fees),
- claims against the estate (i.e., decedent’s debts), and
- casualty or theft losses,
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.
Prior to 2001, the Internal Revenue Code allowed a “credit” against the federal estate tax for state death taxes, but only up to certain limits. Those limits are expressed in this chart:
Because of this limitation, most states simply assessed an estate tax that is equal to the maximum credit that is allowed against the federal estate tax (i.e., the numbers consistent with the above chart). 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, the new estate tax rules do not allow any credit for state estate tax paid. Some states reacted to this by eliminating their estate tax all together (examples include Texas, Florida, Ohio, Kansas, Oklahoma, and 26 others as of 2015). Other states continue to impose an estate tax, with exemption amounts ranging from $675,000 to $2,000,000 or more. The rates in virtually all cases remained in accordance with the former federal rules for the state death tax credit.
For example, New Jersey, as is typical of many 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 have state estate taxes even though they are not subject to the federal estate tax. The rates imposed by New Jersey are the same as the above chart (with the first $675,000 being exempt).