ESTATE AND GIFT TAXATION

H Chapter Fourteen H ESTATE AND GIFT TAXATION INTRODUCTION AND STUDY OBJECTIVES Estate taxes are imposed on transfers of property by decedents, and gift taxes are imposed on the transfers by living individual donors. Historically, the primary function of these two taxes is to inhibit accumulation of assets by redistributing the wealth. Both of these taxes are applied at progressive rates on the value of property transferred. Valuation, accordingly, becomes an important aspect in computing both the estate and gift tax. It also becomes necessary for many income tax purposes such as establishing gain on an exchange or determining the basis of property received. In studying the rules of estate and gift taxation, the student should have these objectives: 1. To learn the rules and definitions related to transfers during the donor s lifetime that are subject to the gift tax. 2. To learn the rules and definitions related to transfers taking place at death that are subject to the estate tax. 3. To understand how the estate and gift taxes are computed on a unified basis. 4. To be familiar with the generation-skipping transfer tax. PROPERTY INTERESTS STUDY HIGHLIGHTS 1. A tenancy in common exists when two or more persons hold title to property, each owning an undivided fractional interest. The ownership percentages do not have to be equal. 2. A joint tenancy is an arrangement where two or more persons hold title to property with each owning an equal fractional share. A joint tenancy normally implies a right of survivorship (i.e., the surviving members take title to the decedent s share of the property). 3. A tenancy by the entirety is a joint tenancy with rights of survivorship between a husband and wife. 4. Community property law allows for married individuals to own an equal undivided interest in all wealth acquired during the course of a marriage, regardless of which spouse made the individual contribution to the marital wealth. 5. If a beneficiary s interest is limited to only the income from property, the beneficiary would have an income interest. If the beneficiary is entitled to that income interest for life, then that interest is referred to as a life estate. The person entitled to the life estate is called the life tenant. If the owner of property requests that the property be returned after the life estate, then the owner has a reversionary interest. If the property passes to someone other than the owner, the interest is called a remainder interest. The holder of the remainder interest is the remainderman. 14-1

14-2 Estate and Gift Taxation THE GIFT TAX 6. The gift tax is an excise tax imposed on the right of the donor to transfer property in the form of a gift. This is often referred to as a transfer tax. The tax applies to gratuitous transfers of property during the taxpayer s lifetime. Taxable gifts, however, do not necessarily require donative intent; they merely require a reduction of the taxable estate. A transfer for full and adequate consideration is not considered a gift. 7. To have a transfer subject to the gift tax, a transfer must be complete. A transfer is considered complete if the donor has surrendered all control over the property. 8. The gift tax is measured by the fair market value on the date of the gift. Estate tax rules for determining value are used in valuing gifts. There is no alternate valuation date for gifts. 9. In computing taxable gifts, a donor is entitled to an annual exclusion. This exclusion is $13,000 per year per donee for 2009. The only requirement to receive this exclusion is that the donee have a present interest in the property. The exclusion will not apply to gifts that the donee will enjoy at some future date. 10. To take advantage of progressive gift tax rates, both spouses will consent to treat a gift of separate property as if it came equally from both spouses. This is known as gift splitting. 11. A gift tax marital deduction allows an individual to make tax-free transfers of wealth to his or her spouse. The deduction is allowable only if certain requirements are met. 12. The formula for computing the gift tax is illustrated as follows: Taxable gifts of the current year $xxxx (net of exclusions) þ Taxable gifts of prior years þ xxxx ¼ Total taxable gifts $ xxxx Tax rates (See Exhibits 14-2 and 14-3) X% in textbook) ¼ Tentative tax on total taxable gifts xxxx Less tax on prior year gifts xxxx Less unified credit xxxx Less foreign gift tax credit xxxx ¼ Gift tax due $ xxxx 13. The Federal gift tax return, Form 709, is filed annually on a calendar year basis. The due date is April 15th after the close of the taxable year. TRANSFERS OF PROPERTY AT DEATH 14. A will is an instrument used by individuals to transfer the ownership of their separate property at death. There are few restrictions on the right of an individual to dispose of property. A will should always name a guardian for the decedent s minor children to avoid years of possible family discord and distress. 15. A person who dies without a will or with an invalid will is said to have died intestate. 16. Probate is the legal process whereby a decedent s will is established as genuine and valid.

Study Highlights 14-3 THE GROSS ESTATE CONCEPT 17. The first step in determining the estate tax due is to obtain the value of the gross estate. The gross estate includes not only property actually owned by the decedent, but also property constructively owned by the decedent. In some cases, gifts made within three years of death may be included in the gross estate. See Exhibit 14-4 in the textbook for a list of specific inclusions in the gross estate. 18. The assets that are identified to be included in the gross estate are valued at fair market value on the date of the decedent s death. If the executor so elects, the fair market value six months after the decedent s death can be used. This is known as the alternate valuation date. 19. A special use valuation under 2032 allows qualifying real estate and closely held corporations to value their property on its business use and not the fair market value (its best use valuation). GROSS ESTATE INCLUSIONS 20. Life insurance proceeds on the life of the decedent must be included in the gross estate if the decedent had any incidence of ownership. This means that the decedent had an economic interest in the policy or the power to change the policy s beneficiaries. 21. Survivor benefits, such as annuities, are includible in the gross estate to the extent that the decedent possessed the right to payment at death. The annuity must have been paid for by the decedent or the decedent s employer. 22. Joint interests in property must be included in the gross estate even if the decedent s spouse had a joint tenancy with rights of survivorship. 23. A power of appointment is the right to dispose of property that the holder of the power does not legally own. A specific power of appointment allows the holder of the power to give the property to members of a specified group. A general power of appointment allows an individual to give the property to himself, his creditors, or his estate. A general power of appointment is tantamount to actual ownership and must be included in the gross estate. 24. If a decedent made an intervivos gift but failed to relinquish control (i.e., strings attached), then the donor is deemed to retain beneficial enjoyment of that property and must include the full value of that property in the gross estate. 25. Transfers for insufficient consideration will be included in the gross estate to the extent of the bargain element. DEDUCTIONS FROM THE GROSS ESTATE 26. Certain deductions are allowable in determining the estate tax liability. These include certain liabilities of the decedent, funeral expenses, administrative expenses, and certain casualty losses occurring during the settlement of the estate. 27. An estate may take a deduction for the transfer of any assets to a qualified charitable organization. If an individual is willing to leave the entire estate to a qualified charity, there will be no estate tax. 28. For years after 1981, a decedent is entitled to an unlimited marital deduction for the value of property passing to one s spouse. If a married taxpayer leaves his or her entire estate to the surviving spouse, no estate taxes will be imposed.

14-4 Estate and Gift Taxation 29. Certain transfers to a spouse may not qualify for the marital deduction because they have a terminal interest. This means that the decedent s death terminated his or her right to that property. In order to qualify the terminal interest property for the marital deduction, Congress enacted in 1981 a special trust known as a qualifying terminal interest property (QTIP) trust. 30. The estate tax is computed as follows: Gross estate $xxxx Adjustments to gross estate xxxx Adjusted gross estate xxxx Deductions xxxx Taxable estate xxxx þ Adjusted taxable gifts þ xxxx Taxable transfers xxxx Applicable rates X% Gross estate tax xxxx Credits xxxx Net estate tax $xxxx 31. The Federal estate tax return is filed on Form 706 and is due nine months after the date of the decedent s death. Under certain circumstances, an extension of time may be obtained and, in addition, a portion of the estate tax liability may be paid in installments for some closely held businesses. THE GENERATION-SKIPPING TRANSFER TAX 32. In 1976, Congress added a third type of transfer tax known as the generation-skipping transfer tax (GSTT). The Tax Reform Act of 1986 retroactively repealed the 1976 version of the GSTT and replaced it with a new tax applicable to transfers after September 25, 1985. The GSTT is very complex and involves transfers using three generations of taxpayers. When a first-generation taxpayer makes transfers to a third-generation taxpayer, the GSTT will treat the second-generation taxpayer as a deemed transferor and a tax will be imposed using the applicable estate and gift tax rates. 33. The Tax Reform Act of 1988 requires that the beneficiary receiving the transfer (the skip person) to be an individual two or more generations below the transferor. This provision is effective for transfers made after October 22, 1986. 34. The first one million dollars is exempt from the generation skipping transfer tax. However, before 1990, direct skip transfers made to grandchildren, of two million dollars or less, are exempted from the tax.

Study Questions 14-5 True or False STUDY QUESTIONS 1. A generation-skipping transfer tax involves three generations of taxpayers. 2. An estate may deduct the value of any transfer of assets to a qualified charitable organization. 3. The unified transfer credit applies only to the estate tax. 4. The transfer of $25,000 from a father to his son as a wedding present would represent a taxable gift. 5. A split gift made by a husband and wife only applies to community property. 6. Under the new unified transfer system, gift taxes paid on a gift of property are merely a prepayment of the estate tax liability, ignoring appreciation or depreciation in value. 7. Wages that are not included on the decedent s final income tax are excluded from his taxable estate. 8. For Federal estate tax purposes, a limited credit is allowed for payments made to the decedent s estate. 9. Tax-exempt bonds owned by the decedent at death will not be included in the decedent s gross estate. 10. Casualty losses on property owned by the decedent are deductible in arriving at the adjusted gross estate. 11. Married taxpayers electing to split gifts may gift a total of $80,000 to their four children without triggering a gift tax liability. Multiple Choice 1. Which of the following items is considered deductible in arriving at the adjusted gross estate? a. Marital deduction. b. Administrative legal fees. c. Charitable contributions. d. All of the above. e. None of the above. 2. D died, leaving a gross estate of $900,000. Of this amount he directed that $400,000 should go to his spouse with the remainder of the estate to be split evenly among his five children. What will be the maximum amount allowed as a marital deduction? a. $100,000. b. $150,000. c. $250,000. d. $400,000. e. $500,000.

14-6 Estate and Gift Taxation 3. Assume the same facts as in 2 above, except that D placed his entire estate in a qualifying terminal interest property trust with the income from the trust to be paid to his spouse throughout her life with the remainder to be paid to D s children. What is the maximum amount of marital deduction that can be taken? a. $0. b. $100,000. c. $250,000. d. $450,000. e. $900,000. 4. D makes a gift of $18,000 to his daughter and a gift of $8,000 to his son on February 1, 2009. These are the only gifts D made during the year. When must a gift tax return, Form 709, be filed? a. Never b. February 15, 2009 c. April 15, 2009 d. January 15, 2010 e. April 15, 2010 5. Which of the following received after a decedent s death is not income in respect to a decedent? a. Salary earned by the decedent but not received prior to death. b. Installment payments from a contract entered into prior to death. c. Rent for the month after the decedent s death but pursuant to a lease entered into prior to death. d. Collection on a cash basis taxpayer s accounts receivable that existed at the date of death. e. Interest earned by the decedent but not received prior to death. 6. Which of the following is not included in the gross estate of the decedent? a. Property held as a joint tenancy with the decedent s spouse. b. U.S. Treasury bonds. c. Life insurance owned by the decedent s spouse. d. A general power of appointment owned by the decedent. e. All of the above are included in the gross estate. 7. On July 20, 2009, R makes a gift of 1,000 shares of X Corporation stock that is traded on a public exchange. T paid $20 per share for the stock two years ago. If the lowest quoted price on July 20 was $30 per share and the highest quoted price on July 20 was $36, compute the value of stock for gift tax purposes. a. $20,000. b. $26,000. c. $30,000. d. $33,000. e. $36,000.

Study Questions 14-7 8. Which of the following situations would not constitute a transfer that comes within the gift tax statutes? a. An individual creates a trust under the terms of which a child is to get income for life and a grandchild is to receive the remainder at the child s death. b. An individual with personal funds purchases real property and has title conveyed to the individual and the individual s brother as joint tenants. c. An individual with his own funds creates a joint bank account for himself and his sister. The sister draws a check on the account for her personal benefit. d. An individual creates a trust giving income for life to his wife and providing that, at her death, the corpus is to be distributed to his son. The individual reserves the right to revoke the transfer at any time without the consent of the other parties. e. An individual with his own funds purchases a U.S. Savings Bond made payable to himself and his wife. His wife surrenders the bond for cash to be used for her benefit. 9. All of the following are allowed as deductions in computing the taxable estate except a. Expenses of administering and settling the estate. b. Claims against the estate. c. Certain casualty and theft losses. d. State inheritance taxes. e. Charitable deductions. 10. On May 6 of the current year, S gifted 10 shares of publicly traded common stock to G. On that date, the highest selling price of the stock was $60 per share, the lowest selling price was $58 per share, and the closing price was $59.50 per share. What is the value of the 10 shares for gift tax purposes? a. $600. b. $595. c. $580. d. $590. e. None of the above. 11. D, a single taxpayer, made the following cash gifts in the current year: To qualified charity A $17,000 To minor child C 25,000 To political party P 11,000 To friend F 6,000 After application of the annual exclusion, what is the total amount of taxable gifts made by D? a. $11,000. b. $15,000. c. $16,000. d. $18,000. e. $23,000.

14-8 Estate and Gift Taxation 12. The property of a person who dies intestate is generally a. Distributed only to the surviving spouse and the state of residence and is not subject to the Federal estate tax. b. Distributed according to the laws of the state of residence and is subject to the Federal estate tax. c. Seized by the state of residence and is subject to the Federal estate tax. d. Distributed according to Federal law and is subject to the Federal estate tax. e. Seized by the Federal government. 13. In 1980, W used her own funds to purchase a $100,000 paid-up life insurance policy on the life of her husband H. W retained ownership of the policy and designated her oldest daughter D as sole beneficiary. The cost of the policy was $60,000. Assume wife W rather than husband H died in the current year. At date of death, the policy had a replacement cost of $72,000. What amount attributable to the life insurance policy is includible in W s gross estate for Federal estate tax purposes? a. $0. b. $50,000. c. $72,000. d. $100,000. e. None of the above. 14. Which of the following actions in the current year completed a taxable gift during donor K s lifetime but did not remove the transferred assets from K s gross estate? a. K transferred assets into a revocable trust for the sole benefit of her daughter W. b. K transferred assets into an irrevocable trust for the sole benefit of her brothers X and Y. K retained the right to decide what proportion of the annual income each brother would receive; however, K retained no control over the ultimate distribution of the trust corpus to X and Y. c. K amended a revocable trust created in 1982 for the sole benefit of her son Z to make the trust irrevocable; K retained no control over the assets of the trust. d. None of the above. e. All of the above

Solutions to Study Questions 14-9 SOLUTIONS TO STUDY QUESTIONS True or False 1. True. 2. True. 3. False. Both estates and gifts. 4. True. 5. False. Applies to noncommunity property as well. 6. True. 7. False. Must be included in the gross estate. 8. True. 9. False. Tax-exempt income is includible in the gross estate. 10. False. Deductible in determining the taxable estate. 11. False. Only if it is a present interest. Multiple Choice 1. b. 2. d. 3. e. 4. e. 5. c. 6. c. 7. d. 8. d. 9. d. 10. d. (60 þ 58) 2 @ 100 shares ¼ $590. 11. b. 12. b. 13. a. 14. b.