Estate Tax

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were pushing for the estate tax to be kept, Republicans have been pushing for a long time for the estate tax to be repealed.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 typically increases each year.

Then, in 2017, the Tax Cuts and Jobs Act doubled the estate tax exemption amount and kept place the yearly inflation increases. In 2020, the amount is $11,580,000 per person and it increases a bit each year.

Rates

The maximum estate tax rate is now 40%. 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 2020, Veronica gifts $815,000 to her daughter, Olive. Assuming Olive had no gift tax exemption remaining, only the amount in excess of the $15,000 exclusion amount would be considered a taxable gift. In addition, if Veronica has met or exceeded her lifetime unified credit, then a $320,000 gift tax liability would be paid by Veronica (40% of the $800,000 that is in excess of the $15,000 annual exclusion). In essence, Veronica is paying $1,135,000 to give Olive $815000.

In contrast, if Veronica dies with no exemption remaining and left $1,135,000 for Olive, 40% of that amount goes to pay estate tax. 40% of $1,135,000 is $454,000. This leaves only $681,600 for Olive. Though both taxes were applied at 40%, the gift tax would cost Olive $124,000 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 is the same as the gift tax lifetime exclusion amount, or $11,580,000 as of 2020 and adjusted each year for inflation. 

This is accomplished via a unified tax credit that corresponds to the amount of tax on a $11,580,000 estate.

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. Only the first $60,000 of a nonresident alien’s US-based estate is exempt from estate tax. For example:

In 2021, 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. The entire estate aside from the $60,000 exemption will be subject to estate tax, even though it is well under the generally applicable $11,580,000 limit. 

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” was a common 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 2020, 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 $20,000,000. 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 $20,000,000 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 (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 ($11,580,000 for 2020, 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 money passes as part of the unlimited marital deduction, thereby avoiding estate taxes. When the second spouse dies, the taxable estate has less than $10,000,000 and so is not subject to estate tax.

However, it is important to note that the credit shelter trust device was rendered unnecessary in many cases by the allowance of “portability” of estate tax exemption, which took effect in 2013. 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 by electing to do so in an estate tax return filed within nine months of death. The credit shelter trust is still used sometimes when the couple wants the assets to be held in trust for other reasons (such as protection from creditors). But please note that in many cases, portability has rendered the credit shelter trust device unnecessary purely as an estate tax savings tool.

Step-up in basis

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:

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
2. 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.

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:

• 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,
• Etc.

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.

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. Thus, most states simply assessed 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 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 current estate tax rules do not allow credit for state estate tax paid. Most states reacted to this by eliminating their estate tax. Other states continue to impose an estate tax, with exemption amounts that vary widely, but are no less than $1,000,000 in any state.

For example, New York, as is typical of many states, had 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 York simply split the total estate tax revenue with the federal government. However, New York initially froze its credit at $1,000,000. In a series of increases since, the New York state estate tax exemption has been increased to $5,000,000 as of 2017 and indexed for inflation after that year. The state maximum estate tax rate is 16%, as opposed to the 40% of the federal estate tax.