Calculating Federal Estate Tax, Analyzing the Client s Estate, and Seminars

Transcription

1 Calculating Federal Estate Tax, Analyzing the Client s Estate, and Seminars 5 Learning Objectives An understanding of the material in this chapter should enable the student to 5-1. Describe the general rule for inclusion of property in the gross estate Define and discuss the gross estate Explain the difference between the gross estate and the taxable estate List the steps used to compute the federal estate tax Compare estate tax deductions and estate tax credits Discuss the unlimited marital deduction Explain the requirements for property to qualify for the marital deduction Discuss the charitable deduction Explain state death taxes and inheritance taxes Explain the generation-skipping transfer tax Discuss the 10 key steps in analyzing the client s estate planning situation Identify the main benefits of and aspects involved in conducting a successful seminar. 5.1

2 5.2 Foundations of Estate Planning Chapter Outline THE FEDERAL ESTATE TAX 5.2 Transfers at Death 5.2 Estate Taxation of Residents, Citizens, and Nonresident Aiens 5.3 CALCULATING THE GROSS ESTATE 5.3 What Is Included in the Gross Estate 5.3 CALCULATING THE TAXABLE ESTATE 5.10 Determining the Adjusted Gross Estate 5.10 THE UNLIMITED MARITAL DEDUCTION 5.11 Qualifying for the Marital Deduction 5.11 THE CHARITABLE DEDUCTION 5.13 STATE DEATH AND INHERITANCE TAXES 5.14 Types of State Taxes 5.15 EGTRRA 2001 and State Death Taxation 5.16 Beneficiary Classes 5.17 Tax Rates 5.17 COMPUTATION AND PAYMENT OF THE FEDERAL ESTATE TAX 5.18 Determination of Tentative Tax Base 5.18 Determination of Estate Tax before Credits 5.18 Determination of Net Federal Estate Tax Payable 5.19 Estate Tax Credits 5.19 Filing the Estate Tax Return 5.21 GENERATION-SKIPPING TRANSFER TAX (GSTT) 5.25 EVALUATING CLIENTS ESTATE PLANNING NEEDS 5.26 Key Steps in Analyzing the Client s Situation 5.26 Advisor s Role in Estate Tax Analysis and Planning 5.29 SEMINAR MARKETING 5.30 Planning a Seminar 5.31 Attracting the Right Audience 5.32 Devising and Presenting a Professional Seminar Program 5.36 Conducting an Effective Follow-up Campaign 5.40 CHAPTER FIVE REVIEW 5.43 THE FEDERAL ESTATE TAX Transfers at Death All property either owned directly by the decedent at the time of death or subject to the decedent s control under one of the federal estate tax rules is

3 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.3 federal estate tax included in the estate for federal estate tax purposes. The way in which property is transferred is irrelevant in this calculation. The property may be transferred by will, intestacy, contract, or operation of law. The federal estate tax applies to the entire estate and is imposed on the estate itself, which is primarily liable for payment of the tax. To the extent that there are assets in the estate, the estate is responsible for paying the tax liability. However, if the estate does not contain sufficient assets to pay the tax, beneficiaries of the estate may be charged with the tax liability to the extent of the value of property they inherit. Estate Taxation of Residents, Citizens, and Nonresident Aliens progressive tax graduated rate schedule All property owned by citizens or residents of the United States at the time of their death is subject to the federal estate tax, regardless of where the property is located. The tax is a progressive tax similar to the federal income tax. It is based on a graduated rate schedule that increases with the size of the estate. The federal estate tax is applied differently to those who are considered nonresident aliens (nonresident noncitizens). For nonresident aliens, only the value of the property located in the United States that they own at the time of their death is subject to federal estate tax. Note that the property owned by noncitizens may also be subject to foreign death taxes, as may foreign property held by U.S. citizens. The federal taxation of such individuals and their property often depends on the terms of the estate tax treaty (if any) between the United States and the applicable foreign nation. CALCULATING THE GROSS ESTATE What Is Included in the Gross Estate Both the size of the estate and the specific property held are significant factors in planning. For estate planning purposes, it is important to anticipate what will be included in a person s estate. Both the size of the estate and the specific property held are significant factors in planning. The concept of the gross estate is crucial because its size and the types of assets it includes determine what planning techniques the financial advisor should employ. Technically, each U.S. citizen or resident who dies has a federal gross estate, even when no federal estate tax is due. A person s gross estate includes everything he or she owned at the time of death. Although this seems fairly straightforward, the Internal Revenue Code defines two components of estate inclusion: what is actually owned and what is deemed to be owned. These two components exist because there are many situations in which estate owners, attempting to avoid estate taxes, transfer property interests so that the estate owner does not actually own the value of that property at the date of death.

4 5.4 Foundations of Estate Planning fair market value alternate valuation date applicable credit amount unlimited marital deduction Although no plan should be implemented without an analysis of the tax consequences, federal estate taxes should not be the controlling factor, regardless of the size of the estate. gross estate The first component actually owned is easy to define. Everything to which the deceased held title is included in the gross estate for tax purposes. The second component deemed or constructively owned is considerably more complicated. Several sections of the estate tax portion of the Internal Revenue Code pull back former property interests into the decedent s gross estate so that the fair market value of that property, either on the date of death or the alternate valuation date, becomes taxable in the decedent s estate. If this were not the case, a transfer of property interest prior to death would successfully defeat the tax. Estate owners often want to have the best of both worlds, so they transfer property to others so that they no longer own it, but as a practical matter, they continue to enjoy the property as if they still owned it. These rules were instituted to prevent estate owners from having their cake and eating it, too. One primary objective of estate planning traditionally has been to obtain the maximum savings in federal and local death taxes, as well as other transfer costs. Most clients want to transfer their property to family members and other beneficiaries at a minimum cost with the least shrinkage to their estates. For most persons with small and medium-sized estates, estate taxes are not a problem. The applicable credit amount shelters the estate from tax, especially under the higher credits available under EGTRRA In addition, the unlimited marital deduction allows married individuals to pass their entire estate to their surviving spouses free of federal estate tax. In spite of these benefits, the federal estate tax must be taken into consideration in planning an estate for the following reasons: The marital deduction is available only at the first death of a married couple (presuming the survivor does not remarry). Inflation may cause even modest estates to exceed the applicable credit amount. The size of the federal deficit might cause Congress, in the future, to look for increased revenue from the estate and gift tax system. Certainly, at this time, the future of the estate and gift tax system is unknown, so it is best to plan on the conservative side. The financial advisor must determine the client s unique estate planning objectives. The effect of taxes on the estate is only one consideration in preparing an estate plan. Although no plan should be implemented without an analysis of the tax consequences, federal estate taxes should not be the controlling factor, regardless of the size of the estate. Secs spell out what is to be included in a person s gross estate. Unless the property is specified in these sections, it does not have to be included in the estate for federal estate tax purposes. Some of the provisions common to estate planning are outlined below.

5 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.5 Sec. 2031: Basic Includibility Sec states that what is to be included in the gross estate is the value of all property, real or personal, tangible or intangible, to the extent provided by Secs Sec does not mention specific property, and is thought of as a master clause, telling us where to look for estate inclusion rules. income in respect of of a decedent (IRD) Sec. 2033: The Catch-All Provision This section provides that the gross estate encompasses any property in which the deceased had an interest. Property defined in Sec includes any interest, real or personal, tangible or intangible, of an individual on the date of death to the extent of his or her interest in the property. Examples are real estate, cash and cash equivalents, stocks, bonds, notes, mortgages, the value of outstanding loans, and the value of tax refunds due to the deceased. If the property is subject to debt, the full amount of the property is included and a deduction can be made for the amount of outstanding debt. All of the decedent s tangible personal property for example, furniture, jewelry, automobiles, and household items is included. Sec addresses not only tangible and intangible assets the decedent actually owned at death but also assets that were due the decedent but not yet received by him or her. All of these assets are included in the decedent s gross estate. Income items that a decedent has already been earned but not collected as of the date of death are called income in respect of a decedent (IRD). Even though these items are taxed for federal income tax purposes, they may also be required to be included as part of the gross estate. They may, therefore, also be subject to federal estate tax. The following are examples of income in respect of a decedent: fees earned by a decedent but not yet paid and collected as of the time of death royalties earned by the decedent but not yet paid rents accrued up to the date of the decedent s death on property owned by the decedent bonuses, unpaid salary, and the like previously earned by the decedent but not yet paid dividends on shares of stock owned by a decedent at the time of death but payable subsequent to death The federal estate tax is levied on the right to transfer property at death. Therefore, if the decedent had no right to transfer property or a property interest to another at death either by will or under the intestacy laws, the value of those property interests is not includible in the gross estate under this section, no matter how great the decedent s interests were during lifetime. An

6 5.6 Foundations of Estate Planning Any property interest that was given to the decedent by another, the transfer of which the decedent cannot control and that ceases at the decedent s death, is not included in the gross estate. example of an interest in property in which the decedent possessed no right to pass at death is a life estate created by another. Any interest in property that was given to the decedent by another, the transfer of which the decedent cannot control and that ceases at the decedent s death, is not included in his or her gross estate. Only inheritable interests (interests that can be transmitted to another by the decedent at death) are subject to the tax. Sec includes in the decedent s gross estate the value of his or her share of property held in conjunction with others. Thus, if the decedent owns property as a tenant in common with others, the decedent s tenancy share is includible in the gross estate. If disproportionate shares as tenants in common are not specified, the interests are presumed to be equal. For example, if there are three tenants, they are each presumed to own a one-third interest. The value of the decedent s share of community property is included in the estate. Sec Inclusion Real property Cash/money equivalents Stocks/bonds Notes Mortgages Outstanding loans by decedent to others Income tax refunds due Patents/copyrights Damages owed decedent Dividends declared and payable Income in respect of decedent (IRD) Partnership/unincorporated business interests Tangible personal property Vested future rights Decedent s share of property held with others Sec. 2035: Inclusion of Certain Gifts, Transfers and Gift Taxes Generally, property already transferred from the estate is not included in the gross estate except under certain conditions. Property transferred is included if the transfer took place within 3 years of death in the following situations: The donor maintained a retained interest for life. The transfer took place at death. The donor held the right to reverse or revoke the transfer. Gift taxes were paid on the transfer. The property transferred was a life insurance policy.

7 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.7 All of these items are included in the gross estate if the transfer took place within 3 years of the decedent s death. The last item the transfer of a life insurance policy requires further explanation. Gifts of Life Insurance within 3 Years of Death. One type of inclusion under Sec pertains to gratuitous transfers (gifts) of life insurance made by the insured within 3 years of death. Gifts of life insurance policies made within 3 years of death are includible in the gross estate whether or not a gift tax return was required to be filed. Life insurance is an unusual product because its value as a gift for gift tax purposes may easily fall below the level of the annual exclusion amount necessary to file a gift tax return or to make a taxable gift. Yet the value of the proceeds is undoubtedly much more substantial than any gift tax value. Sec Sec. 2038: Transfers with Retained Life Interests, Transfers That Take Place at Death, and Revocable Transfers These sections address property that is transferred prior to death but in which the donor retains some rights. This includes any rights where the decedent could still control, possess, or enjoy property directly or indirectly, or where he or she could control in any way who should possess or enjoy the property or the income from the property. These sections get quite complex; for this course, it is necessary that you understand the intent of the sections, not the specific details. Here is one example. Example: If the owner of a controlling interest of stock in a business transfers his or her stock but keeps the right to vote the shares, those shares will be included in his or her gross estate. A controlling interest is at least 20 percent of all voting shares. If the shares do not control the corporation, they are not included. In determining if the decedent owned a controlling interest (20 percent of the voting stock), all of the stock held by the decedent and his or her family spouse, children, grandchildren, and parents is counted as being owned by the decedent. This is known as the family attribution rule, and if not considered carefully in planning, it can create significant estate tax problems by returning distributed stock to the gross estate. Here are three more examples of retained life interests.

8 5.8 Foundations of Estate Planning Example 1: Example 2: Example 3: Michael makes a gift to Rachael of a Renoir painting, but he reserves the right to keep the painting in his home for his lifetime. The value of the painting is includible in Michael s estate. Matthew conveys his personal residence to Nancy but reserves the right to occupy the premises rent free during his lifetime. The value of the property at the time of Matthew s death is includible in his gross estate. Samantha transfers her home to her son, Henry, reserving the right to the income from the property for 10 years. Samantha dies in the 8th year. The entire value of the home is includible in Samantha s estate because she reserved an income interest not for her lifetime but for a period that did not, in fact, end before her death. As you can see in these examples, the estate tax law can become rather complicated in order to close loopholes and prevent techniques that taxpayers and their legal counsel might try to use to avoid paying federal estate taxes. Sec. 2039: Annuities Sec addresses the inclusion of annuity products. Generally, the value of an annuity is included in an individual s gross estate if the decedent had the right to the payments during his or her lifetime and payments continue beyond his or her death. Annuities that end at death are not included because the decedent had no transferable interest in them. Benefits under an annuity contract are always valued on the date of death. If property is held jointly by a husband and wife, one-half of the fair market value is automatically included in the gross estate of the first to die. The actual contribution of each spouse is irrelevant. Sec. 2040: Jointly Held Property with Right of Survivorship This section deals with property that is owned jointly. Property held jointly by a husband and wife is treated differently from property held jointly with others. If the property is held jointly by a wife and husband, one-half of the fair market value is automatically included in the gross estate of the first to die. The actual contribution of each spouse is irrelevant. If the property is held jointly with someone other than a spouse, the percentage of ownership attributable to the decedent s gross estate depends on the amount of his or her percentage of contribution to the joint ownership.

9 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.9 power of appointment Sec. 2041: Powers of Appointment This section pertains to powers of appointment. The gross estate includes the value of property subject to a general power of appointment held by the decedent at the time of his or her death. A power of appointment is an interest in the disposition of property given by the property s owner to another person, known as the holder of the power. In other words, the holder of the power has the right to determine the final disposition of the property. The ultimate recipient of the property is known as the appointee. If the power of appointment gives the holder the unlimited right to dispose of the property, including for the holder, it is known as a general power of appointment. If the right is restricted to designate the property to a specific group or class, it is known as a special power of appointment. If the decedent s power is limited, the property is not included in the gross estate. Sec. 2042: Life Insurance The cash value of life insurance owned by the decedent on the lives of others is included in the gross estate. The face value of life insurance owned by the decedent on his or her own life is included under Sec Sec defines when life insurance is included in an estate. Under Sec. 2042, the proceeds of a life insurance policy are includible in the decedent s estate in the following circumstances: The decedent had any incidents of ownership in the policy. The proceeds are payable to the estate. The proceeds are receivable by another for the benefit of the estate. incidents of ownership Incidents of ownership refers to the rights to and degree of control that a policyowner or the policyowner s estate has in the economic benefits of a life insurance policy. The concept is not limited to ownership in a technical sense. Rights that are considered to be incidents of ownership include the power to name or change beneficiaries right to assign the policy or to revoke an assignment right to surrender or cancel the policy right to pledge the policy as collateral for a loan right to take a loan against the cash surrender value of the policy There are other incidents of ownership that can cause a policy s proceeds to be included in a person s gross estate, but these are the most common. We will discuss this subject further in chapter 7.

10 5.10 Foundations of Estate Planning CALCULATING THE TAXABLE ESTATE Once the gross estate has been determined, the taxable estate can be calculated. To determine the taxable estate, it is first necessary to determine the adjusted gross estate. This calculation is not required for the federal estate tax return (Form 706) but has value for other calculations. adjusted gross estate Determining the Adjusted Gross Estate The adjusted gross estate is calculated by subtracting certain allowable costs from the gross estate. Some of the items included may be deducted from either the decedent s final income tax return or the estate tax return, but they cannot be deducted from both returns. These items are as follows: funeral expenses. Funeral expenses, limited to a reasonable amount, can be deducted for estate tax purposes. These expenses include the cost of interment, the burial plot, the grave marker, and services of the funeral director. Travel costs for relatives are generally not allowed as deductions. administration expenses for property subject to claims against the estate. The cost of administering the property included in the gross estate is usually deductible from either the estate tax return or the estate s income tax return. Attorney fees, accounting fees, court costs, settlement fees, and the executor s commission are all examples of allowable expenses. Expenses that benefit one or more heirs directly are generally not allowed as deductions. Medical expenses related to the decedent s last illness may also be deducted on either the estate tax return or the decedent s final income tax return, but not on both. claims against the estate. All claims and debts owed by the decedent at death can be deducted from the gross estate. Taxes, including federal income taxes due, interest on indebtedness, unpaid gift taxes, and property taxes accrued to the date of death are deductible on the federal estate tax return. unpaid mortgages. The full unpaid balance of a mortgage, including interest accrued to the date of death, can be deducted from the gross estate if two conditions are met: The full value of the property must be included in the gross estate. The estate must be liable for the amount of the mortgage. other administrative expenses. The expenses associated with administering property that is not part of the probate estate jointly held property, for example can be deducted.

11 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.11 casualty and theft losses. Casualty and theft losses are deductible expenses, but only to the extent that they are not compensated by insurance. The loss must have occurred during the estate settlement process and before the estate was closed. Such a casualty loss to property permits a deduction from the gross estate for either estate tax or estate income tax purposes. The estate, however, may not claim the same deduction on both returns. Once the adjusted gross estate is determined, three additional adjustments are allowed to determine the taxable estate: the unlimited marital deduction charitable deduction(s) the state death tax deduction THE UNLIMITED MARITAL DEDUCTION The provisions of the unlimited marital deduction are that a donor can transfer an unlimited amount of property to his or her spouse without incurring gift or estate taxes. This includes property transferred either during the donor s life or at death. Generally, to qualify for the marital deduction, the property must be transferred in a way that includes it in the surviving spouse s estate. Estate taxation is not avoided; it is only delayed until the surviving spouse dies. Qualifying for the Marital Deduction This does not mean that there are no restrictions in transfers between spouses. For property to qualify for the unlimited marital deduction, certain requirements have to be met: The spouse must be a U.S. citizen. The property must be included in the estate. The property must transfer directly to the spouse. There must be marital status at the time of the transfer. The transfer must meet the terminable interest rule. Spouse Must Be U.S. Citizen The marital deduction is generally allowed only for spouses who are U.S. citizens. The assumption underlying the marital deduction is that it does not eliminate taxes but only defers them to the second death. Because the

12 5.12 Foundations of Estate Planning government has no right over property held outside the country by a noncitizen, property transferred to a nonresident-alien spouse could escape federal estate taxation. resident alien If the resident-alien spouse is the first spouse to die and property is transferred to the surviving citizen spouse, the marital deduction is allowed. Transfers to a Surviving Resident-Alien Spouse. Although the marital deduction provides an opportunity for a married couple to avoid federal estate taxes at the death of the first spouse, it is not available for property passing to a surviving resident-alien spouse. A resident alien is one who resides in the Unites States but is not a U.S. citizen. This limitation on the use of the marital deduction reflects Congress s concern that if a surviving resident-alien spouse were to receive marital assets at the death of the citizen spouse, the survivor could return to his or her home country with these assets. Because the United States does not have jurisdiction to tax a nonresident alien for property located outside of the country, the assets transferred to the surviving resident-alien spouse could completely avoid federal estate and gift taxation. The fundamental concept of the marital deduction is that the wealth will be subject to transfer tax at the second spouse s death. If, however, the resident-alien spouse is the first spouse to die and property is transferred to the surviving citizen spouse, the marital deduction is allowed. In this case, transfer taxes can be imposed whenever the surviving U.S. citizen spouse transfers the property. Qualified Domestic Trust (QDOT). A qualified domestic trust can be used to take advantage of the marital deduction when the surviving spouse is a noncitizen. This topic is discussed in detail in chapter 8. Property Must Be Included in Estate Property must belong to the donor before it can be included in the marital deduction. In other words, if the property is not included in a person s gross estate, it cannot be included in the marital deduction. Example: No marital deduction is allowed when a wife purchases a life insurance policy on her husband s life with her own funds and is the owner and beneficiary of the policy. Because the proceeds of the policy are not includible in the husband s gross estate in the first place, they do not qualify for a marital deduction. However, if for any reason the life insurance proceeds are includible in the decedent s gross estate, they can qualify for the marital deduction if passing to the surviving spouse.

13 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.13 Property Must Transfer Directly Property must be exchanged directly between spouses as opposed to moving through a third party. Property left to a son who elects to return it to his mother, for instance, does not qualify. This provision also means that the spouse must have ownership rather than serve as a trustee for someone else. To meet this requirement, the property must be transferred during the donor s lifetime by will or intestacy by election against the will 1 through life insurance proceeds by survivorship Must Have Marital Status To qualify for the marital deduction, the couple must be married on the date of the transfer, or on the date of death if it is a testamentary transfer. The spouse must also survive the donor. terminable interest Must Meet Terminable Interest Rule In general terms, to qualify for the marital deduction, the property must be includible in the surviving spouse s estate. If the surviving spouse has a terminable interest his or her interest is limited or restricted and is capable of being terminated then the property does not qualify for the deduction. It is not required that the contingent event actually occur. This provision simply requires that the surviving spouse s interest cannot terminate in property qualifying for the marital deduction so as to eliminate it from the surviving spouse s estate. This topic will be covered in greater detail in chapter 6. THE CHARITABLE DEDUCTION It is possible for a charitable contribution made during the donor s lifetime to generate both an income tax deduction and an estate tax deduction. An estate tax charitable deduction is allowed for the full value of property transferred to a qualified charity if the property is included in the donor s gross estate. As with income tax rules about gifts to qualified charities, there are specific rules governing charitable gifts for the estate. It is possible for a charitable contribution made during the donor s lifetime to generate both an income tax deduction and an estate tax deduction if the value of the property is includible in the donor s gross estate. The value of a lifetime transfer may be included in the gross estate if the donor retains some interest in the property or powers over the property for life. A gift of a life insurance policy to a qualified charity made within 3 years of the donor s death and includible in the gross

14 5.14 Foundations of Estate Planning charitable deduction estate also qualifies for the deduction. If the gift is testamentary made at death through the donor s will it is deducted from the gross estate on the estate tax return. As discussed in chapter 3, the charitable deduction is unlimited for property passing to a qualified charity as defined in the Code. (See chapter 3 for a detailed definition of what constitutes a charitable organization.) Charitable giving is an effective way to reduce estate taxes. Charitable deductions are subtracted from the adjusted gross estate before the amount of estate tax due is calculated. Those who want to make a charitable contribution at their death can do so by purchasing a life insurance policy and naming the charity as beneficiary. To ensure that the planned gift is not included in the estate and to make the gift of the annual premium a gift of present interest the charity should be the owner and premium payer of the policy, as well as being the beneficiary. As explained in chapter 3, a donor who makes a gift to a qualified charity will receive a charitable deduction equal to the value of the gift to the extent that it is not already covered by the annual exclusion. Remember that lifetime gifts benefit from an $12,000 annual exclusion (in 2006). A $12,000 gift to a qualified charity, therefore, is not treated as a charitable deduction because it is already covered by the annual exclusion. If the gift is $20,000, the first $12,000 is covered by the annual exclusion, and the remaining $8,000 qualifies for the charitable deduction. Generally, for federal income tax purposes, an individual can deduct qualified charitable present-interest contributions of up to 50 percent of his or her adjusted gross income in the year the gift is made. The amount of a gift in excess of 50 percent of the adjusted gross income for the year can be carried forward and applied as an income tax deduction over the next 5 years. STATE DEATH AND INHERITANCE TAXES state death tax Estates too small to trigger the federal estate tax can easily rack up thousands of dollars in state death taxes and probate costs. The subject of state death taxes is typically overshadowed by the attention given to the federal estate tax. Although the emphasis on federal estate taxation is warranted for estates that have a value of more than the applicable exclusion amount, statistically this tax affects a relatively small percentage of all estates settled (1 to 2 percent). On the other hand, most estates are within reach of the state death tax. Therefore, state death tax planning is an important component of the overall estate planning process, albeit to varying degrees. Many states impose their own taxes and costs when residents die. Estates too small to trigger the federal tax can easily rack up thousands of dollars in state death taxes and probate costs. Far from being repealed along with the federal tax, this state burden is on track to rise over time. Consider the following:

15 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.15 Some states have their own estate or inheritance tax systems that are independent of the federal estate tax system. Another group of states is imposing new estate taxes to make up for revenue from the waning federal tax. Finally, some states have expensive and lengthy probate systems that apply to an increasing number of estates. In addition to planning for federal estate taxes, estate planning must consider the effect of state inheritance and death taxes. Every state, the District of Columbia, and Puerto Rico have some form of estate or inheritance tax. The effect of these taxes can be especially significant if property passes to someone other than a surviving spouse. The concern increases greatly if the decedent owned property in more than one state. In this case, each state involved may claim a right to tax the transfer of that property or, in some cases, the entire estate. If the deceased has residences in more than one state and domicile is not clearly established, the intangible property of the decedent may be taxed in all of those states. If a person establishes a trust in a state other than his or her resident state, both states have the right to collect death taxes on the trust property. Types of State Taxes The individual states use three different kinds of estate taxes: state inheritance tax state estate tax credit estate tax state inheritance tax Generally, the closer the beneficiary s blood relationship is to the decedent, the lower the state inheritance tax rate and the greater the exemption. State Inheritance Taxes The state inheritance tax derives from the beneficiary s right to inherit property from the decedent s estate. The tax is based on the value of the property received by each beneficiary, generally at a graduated rate. The rate may depend on the beneficiary s relationship to the deceased and the value of the property. Generally, the closer the beneficiary s blood relationship is to the decedent, the lower the tax rate and the greater the exemption. Because many states have opted to impose an estate tax or credit estate tax during recent years, fewer than one-third of the states currently have an inheritance tax. State Estate Taxes State estate taxes, which are similar to the federal estate tax, are imposed on the decedent s right to transfer or pass property to his or her heirs. This differs from the inheritance tax, which is imposed on the beneficiary s right to inherit.

16 5.16 Foundations of Estate Planning Credit Estate Taxes (Prior to 2005) States used credit estate taxes to capture the maximum amount of taxes up to the amount of state death taxes allowed to be credited against the federal estate tax. In other words, if the computed state inheritance or estate tax was less than the federal estate tax credit allowed for state death taxes, the state assessed the difference, allowing it to collect at least as much as the federal estate tax credit amount. Prior to 2005, all states imposed a credit estate tax. A dollar-for-dollar credit amount was applied against the federal estate tax payable. Example: For a federally adjusted taxable estate of $840,000, assume that federal government allowed a tax credit of $27,600 for state taxes. If the computed state tax amounted to only $25,000, the remaining $2,600 allowed by the federal credit was also collected under the state credit estate tax provisions. EGTRRA 2001 and State Death Taxation EGTRRA 2001 made some significant changes to state death taxation. Beginning in 2005, the state death tax credit was fully repealed and replaced with a deduction for any amount of state death taxes paid. Under the EGTRRA 2001 rules, states with no death tax would truly be left with no state death tax revenue. Hence, the federal rules have encouraged the states, especially states with only a federal state death tax credit, to legislate new state death tax laws. Although many states have varying types of inheritance tax and/or estate tax, all states have at least this tax credit pick-up or sponge tax, even those states that claim to have no death tax. The states rational: Why turn down what the federal government will take out of its own pocket and allow the state to have? The loss of revenue has had an understandably negative effect on the state coffers. Consequently, many states have acted to prevent future death tax revenue losses by decoupling from (eliminating the interrelationship) the EGTRRA state credit phaseout and federal exclusion increases. Although the decoupling arrangements vary from state to state, the simplest form of decoupling is when a state uses the full federal credit that was available prior to the 2001 changes. In other words, those states froze the amount of the state death tax credit allowed before EGTRRA 2001 for state death tax purposes. (The state death tax credit is also discussed in the section titled Estate Tax Credits later in this text.)

17 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.17 Ignoring state tax laws in planning can lead to expensive consequences that can undermine an otherwise well-designed estate plan. Beneficiary Classes In most states, beneficiaries are divided into classes based on their relationship to the decedent. The closest relatives are subject to the least amount of tax and the largest exemption. It is extremely important to understand the state tax laws in the states in which you practice. Ignoring them in planning can lead to expensive consequences that can undermine an otherwise well-designed estate plan. Example: For inheritance tax purposes, state X has six possible classes: Class Class Member Exemption 1 Spouse Full 2 Lineal issue and adopted children $25,000 3 Lineal ancestors $5,000 4 Siblings and their descendants $500 sons and daughter-in laws 5 Siblings of parents and their $100 descendants 6 Others None Tax Rates There are two types of tax rates that states that have death taxes use: flat percentage graduated percentage In states with a flat rate, the value of the whole share passing to a beneficiary is taxed at the same percentage rate. The flat rate may vary, however, according to the beneficiary s degree of blood relationship to the decedent. Example: Tony, the decedent s son, inherited $100,000 from his father. The state provides for a flat tax rate of 6 percent for class 1 (direct lineal descendants of the deceased). There are no exemptions. Tony s state tax is $6,000. Martha, the decedent s niece, inherited $10,000. State law mandates that all beneficiaries other than direct lineal descendants and ancestors belong to class 2 and are taxed at a flat 15 percent rate. Martha s state tax is $1,500.

18 5.18 Foundations of Estate Planning COMPUTATION AND PAYMENT OF THE FEDERAL ESTATE TAX taxable estate The taxable estate is determined by deducting all allowable estate debts, taxes, and administration expenses from the gross estate. The marital deduction and the charitable deduction may also be applicable. As explained in a previous section, under EGTRRA 2001, a state death tax deduction replaced the state death tax credit beginning on January 1, The result is the taxable estate. This section discusses the remaining calculations necessary to compute the federal estate tax. These steps determine the tentative tax base estate tax before credits net federal estate tax payable adjusted taxable gift Determination of Tentative Tax Base After the taxable estate is determined, the amount of adjusted taxable gifts made after 1976 is added to the taxable estate. The result is the tentative tax base. Adjusted taxable gifts are taxable gifts made after 1976 that are not includible in the decedent s gross estate. (The term taxable in this context means either that gift incurred the gift tax liability or that the applicable exclusion amount [credit equivalent] applied to the gift.) Consequently, the following are excluded from treatment as adjusted taxable gifts: post-1976 gifts within the amount of the annual exclusion gifts to a spouse that qualify for the gift tax marital deduction gifts that qualify for the gift tax charitable deduction gifts that have already been included in the decedent s gross estate educational and medical expense exclusion amounts A unified estate and gift tax system means that the same rate schedule is applied to property transfers during a decedent s lifetime and at death. Determination of Estate Tax before Credits The Tax Reform Act of 1976 (TRA 76) created a unified estate and gift tax system. This means that the same rate schedule is applied to property transfers during a decedent s lifetime and at death. The system uses a cumulative approach to all transfers made during lifetime, culminating in the final transfer of property at death. Combining taxable lifetime gifts with transfers at death results in increasing the tax rates applied to the taxable estate by adding adjusted taxable gifts to the value of transfers that take effect at death. Because the estate and gift tax rate schedule is progressive, any individual who made lifetime taxable gifts after 1976 is subject to a

19 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.19 tentative tax higher combined estate tax rate. In other words, this transfer tax rate schedule applies to accumulated transfers, and the result is the tentative tax. Once the tentative tax is determined, gift taxes generated by taxable gifts made after 1976 in excess of the applicable credit amount are subtracted from this figure. The steps to calculate the amount of reduction allowable because of taxes attributable to post-1976 taxable gifts are as follows: Total all post-1976 taxable gifts. Compute the gift tax payable by applying the rate schedule in effect at the decedent s death to the total taxable gifts. All the post-1976 taxable gifts are treated as if they were made at one time the date of the decedent s death. Reduce the gift tax payable by the applicable credit amount for the year of the decedent s death (for gift tax purposes, the credit amount is $345,800 after 2001). If the gift tax payable exceeds the applicable credit amount, subtract the excess from the tentative tax. The result is the estate tax payable before credits. net federal estate tax payable Determination of Net Federal Estate Tax Payable After the computation of the estate tax, there are four possible credits that may be applied to arrive at the net federal estate tax payable. As with income tax credits, these credits are allowed as a dollar-for-dollar reduction of the estate tax. The four credits are the applicable credit amount credit for foreign death taxes credit for gift tax paid on pre-1977 gifts credit for taxes paid on prior transfers No refund is allowed if the sum of the credits exceeds the estate tax otherwise payable. It is important to distinguish between tax deductions and tax credits. Estate tax credits are much more valuable than estate tax deductions. Estate Tax Credits It is important to distinguish between tax deductions and tax credits. Estate tax deductions, discussed in the previous section, are subtracted from the gross estate or adjusted gross estate before calculating the amount of estate tax due. Estate tax credits, on the other hand, are allowed as a dollar-for-dollar reduction of the estate tax due. Consequently, as in income taxation, estate tax credits are much more valuable than estate tax deductions.

20 5.20 Foundations of Estate Planning unified credit Applicable Credit Amount Under TRA 76, the unified estate and gift tax credit came into existence for estates of decedents dying after December 31, The term unified credit was adopted because the credit was to be used as an offset against gift taxes as well as estate taxes. Actually, the credit must first be used to offset gift taxes on lifetime transfers. Any remaining credit is applied as a credit against the federal estate tax. After 1997, the unified credit became known as the applicable credit amount, and it increased incrementally until EGTRRA The credit for 2001 was $220,550, and the applicable exclusion amount (credit equivalent) was $675,000. EGTRRA 2001 made a number of fundamental changes to the federal wealth transfer tax system. The act set in motion the eventual repeal of the federal estate tax while, curiously, retaining the gift tax. A modified carryover basis replaces the transfer tax in The applicable exclusion amount is $2 million in 2006, 2007, and 2008; $3.5 million in 2009; and repealed in In addition, the federal transfer tax marginal rates are reduced from 2002 to In 2006, the maximum federal estate rate is 46 percent; it is 45 percent for 2007, 2008, and The top marginal rate for gift taxes after the estate repeal in 2010 is a flat (no longer progressive) rate of 35 percent. State Death Tax Credit (Repealed) As explained earlier, before 2005, there was a credit against the federal estate tax for any estate or inheritance taxes paid to a state. The credit for state death taxes was limited to the federal estate tax liability after reduction by the applicable credit amount. EGTRRA 2001 replaced the state tax credit with a state death tax deduction. In 2005 through 2009, an estate may take a deduction from the adjusted gross estate on the federal estate tax return for state death taxes actually paid. Credit for Foreign Death Taxes There is a credit allowed for U.S. citizens and noncitizen resident aliens against the federal estate tax for estate and inheritance taxes paid by the decedent s estate to any foreign country. The purpose of the credit for foreign death taxes is to prevent double taxation. Credit for Gift Tax Paid on Pre-1977 Gifts Gift taxes payable on post-1976 gifts have become part of the calculation to determine estate tax liability under the gift and estate tax system.

21 Chapter 5 Federal Estate Tax, Analyzing the Estate, and Seminars 5.21 Therefore, no separate credit is allowed for taxes attributable to these gifts. A credit still exists, however, for federal gift tax paid by a decedent on taxable gifts made before 1977 if the property is included in the gross estate. The credit for tax on prior transfers is designed to avoid double taxation on property the decedent recently inherited. Credit for Tax on Prior Transfers This credit is designed to avoid double taxation on property the decedent recently inherited. It applies to property inherited in the 10 years prior to the decedent s death (or 2 years after his or her death) if the property was already taxable in the original owner s estate. The credit is limited to the lesser of the amount of federal estate tax attributed to the property in the donor s estate the amount attributed to the property in the current decedent s estate If the decedent received the property in the 2 years prior to or following his or her death, the full credit is allowed. If the transfer was more than 2 years prior to the decedent s death, the amount allowed is reduced. Figure 5-1 demonstrates the steps in the computing the federal estate tax, figure 5-2 illustrates a sample calculation for an estate tax in 2006, and figure 5-3 shows the rate schedule for computing estate and gift taxes for 2002 and beyond. Filing the Estate Tax Return The personal representative (executor/administrator) of the estate of every U.S. citizen or resident must file Form 706 the United States estate tax return if the value of the gross estate plus adjusted taxable gifts on the date of death exceeds the filing requirement amount. For filing to be required, the gross estate and adjusted taxable gifts must exceed the applicable exclusion amount. The personal representative is also responsible for paying any estate tax due for which the estate is liable, and for filing any estate income tax returns when they are due. The estate tax return is due no later than 9 months after the decedent s death unless an extension is granted. The extension is limited to 6 months. There is an extension of up to 12 months to pay the estate tax if the IRS determines there is a reasonable cause. If the estate assets are insufficient to pay all the decedent s taxes, the decedent s federal tax liabilities must be paid first (decedent s income tax liabilities up to the time of death, estate income tax, and the estate tax liability). The executor or administrator will be held personally liable for the tax if he or she was aware of a potential tax liability or failed in the

22 5.22 Foundations of Estate Planning FIGURE 5-1 Computation of Federal Estate Tax minus equals minus equals plus equals compute minus equals minus equals STEP 1 (1) Gross estate $ (2) Funeral and administration expenses (estimated as % of ) $ (3) Debts and taxes (4) Losses ( ) STEP 2 (5) Adjusted gross estate $ (6) Marital deduction $ (7) Charitable deduction (8) State death tax deduction 1 ( ) STEP 3 (9) Taxable estate $ (10) Adjusted taxable gifts (taxable portion of post-1976 lifetime taxable transfers not included in gross estate) + (11) Tentative tax base (total of taxable estate and adjusted taxable gifts) $ (12) Tentative tax $ (13) Gift taxes payable on post-1976 gifts 2 ( ) STEP 4 (14) Estate tax payable before credits $ (15) Tax credits (a) Applicable credit amount $ (b) Allowable state death tax credit 3 (c) Credit for foreign death taxes 4 (d) Credit for gift tax for pre-1977 gifts 5 (e) Credit for tax on prior transfers ( ) STEP 5 (16) Net federal estate tax payable $ through 2009 (replaces Step 4(15)(b)). 2. Once the tentative tax is determined, gift taxes generated by taxable gifts made after 1976 in excess of the applicable credit amount are subtracted from it. 3. Repealed in 2005 and replaced with a deduction in 2005 through 2009 as shown in Step 2(8). 4. Irrelevant credit for purposes of this course. 5. Credit still exists for gift taxes paid by a deceased on taxable gifts made before 1977 if the property is included in the gross estate. Irrelevant credit for purposes of this course.