Estate and Gift Taxation
Estate and Gift Taxation
Congress generally imposes an estate and gift tax on large transfers of wealth between individuals. In essence, they are tolls imposed on the transfer of wealth. The Federal Gift Tax (26 USC 2501) is imposed on transfers made during an individual's lifetime, and The Federal Estate Tax (26 USC 2001) is imposed on transfers made at the time of death. Gift taxes and estate taxes are paid separately, but they are subject to a single graduated rate schedule that applies to the cumulative total of taxable transfers made through gifts and estates.
Each year, the taxpayer must report the amount of taxable gifts he or she made during that year. Upon death, an estate tax return is filed on behalf of the decedent's estate. The tax is determined by adding the total lifetime taxable gifts to the taxable estate, and then applying the applicable tax rate. Like the federal income tax, the rates for the estate and gift taxes are graduated. Accordingly, the marginal rates of tax increase as the amount of wealth transferred increases. The maximum rate for estate and gift taxes since 1986 has been 55 percent. Congress, however, amended the law so that this maximum rate will decrease gradually until it is fully phased out in 2010.
For purposes of imposing the estate tax, the law requires that the decedent's property be valued. The taxable estate includes the value of all property controlled by the decedent at the time of death, including such items as life insurance, retained interests in trusts, and powers of appointment. However, the value of debts, funeral expenses, and costs of administering and settling the estate can reduce the estate's residual value. Furthermore, any portion of a decedent's estate that is given to a spouse or to charity is not taxed.
Generation–Skipping Transfer Tax. Closely related to the estate and gift tax provisions is the Generation–Skipping Transfer Tax. Congress created the Generation–Skipping Transfer Tax to prevent taxpayers from skipping several generations of tax on wealth transfers through a succession of life estates. Since the federal estate tax is only applicable where the decedent retained control over property at the time of death, it would not apply to an inherited life estate, which, by definition, terminates on death. The Generation–Skipping Transfer Tax imposes the highest tax rate on transfers deemed to be generation skips. In other words, Congress wants to insure that the value of wealth is taxed anytime it is passed from one generation to the next. The "toll" on wealth is collected, even if the decedent did not have property subject to the estate tax. To understand the law, consider a situation in which a grandfather passes a life interest in a trust worth $25 million to his son, with the remainder going to his grandson. The son gets the use of the $25 million for life, but owns nothing of the trust on death, since his life interest will have terminated. Accordingly, there will be no federal estate tax collected on the transfer of the property to the grandson, because the son did not have the right to control the property. The son's rights disappeared upon his death. The Generation-Skipping Transfer Tax, however, will apply to insure that the wealth transmitted from the son's generation to the grandson's generation does not escape taxation.
MAJOR PROVISIONS OF THE ESTATE AND GIFT TAX
The Annual Gift Exclusion. Each taxpayer is allowed to transfer $11,000 in present interest gifts to any single individual in the course of a year, tax-free. This means that the taxpayer will not be subject to the estate, gift, or generation–skipping taxes just described. The exemption, however, does not apply to transfers of future interests. The exemption is available for as many recipients as the donor chooses. For example, a taxpayer wishing to give away $99,000 to his nine grandchildren could do so tax-free (if the gifts were split evenly) in 2003. This means that the only way gifts can be taxed is if a single taxpayer gives more than $11,000 to each individual or to any one person.
Major Estate and Gift Tax Deductions: The Marital Deduction. A taxpayer can transfer any amount of money or property to a spouse without incurring either estate or gift tax, provided that the transfer to the spouse qualifies for the marital deduction. In order to qualify for the marital deduction, the property must be of a kind that can be included in the surviving spouse's estate upon his or her death. The idea behind the marital deduction is that each couple's property should only be taxed once.
The Charitable Deduction. The Internal Revenue Code provides for a deduction for all amounts transferred to charity during the decedent's lifetime, or at death. A charitable contribution is defined as a bequest, legacy, devise, or transfer:
- • To or for the use of the United States, any State, any political subdivision thereof, or the District of Columbia, for exclusively public purposes
- • To or for the use of any corporation organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, including the encouragement of art, or to foster national or international amateur sports competition (but only if no part of its activities involve the provision of athletic facilities or equipment), and the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or individual, which is not disqualified for tax exemption under section 501(c)(3) by reason of attempting to influence legislation, and which does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office
- • To a trustee or trustees, or a fraternal society, order, or association operating under the lodge system, but only if such contributions or gifts are to be used by such trustee or trustees, or by such fraternal society, order, or association, exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, such trust, fraternal society, order, or association would not be disqualified for tax exemption under section 501(c)(3) by reason of attempting to influence legislation, and such trustee or trustees, or such fraternal society, order, or association, does not participate in, or intervene in (including the publishing or distributing of statements), any political campaign on behalf of (or in opposition to) any candidate for public office
- • To or for the use of any veterans' organization incorporated by act of Congress, or of its departments or local chapters or posts, no part of the net earnings of which inures to the benefit of any private shareholder or individual. For purposes of this subsection, the complete termination before the date prescribed for the filing of the estate tax return of a power to consume, invade, or appropriate property for the benefit of an individual before such power has been exercised by reason of the death of such individual or for any other reason shall be considered and deemed to be a qualified disclaimer with the same full force and effect as though he had filed such qualified disclaimer.
ESTATE TAX CHANGES
In June, 2001, Congress passed legislation that significantly increased the amount that is tax exempt, and significantly reduced the maximum tax rate on taxable property. While this law contained many details, the most notable feature is that the estate tax is scheduled to be phased out by 2010. The law will continue to tax gifts. After 2011, the estate tax provisions revert back to their 2001 rates, with the first million dollars of taxable transfers remaining exempt. Technically, therefore, the estate tax repeal will only last one year.
The 2001 changes also affect individuals who receive property from an estate. Currently, a person acquiring property from a decedent takes a "basis" in that property equal to the fair market value at the date of the decedent's death. Beginning in 2010, however, the transferee will take the decedent's basis, rather than a basis equal to the fair market value. This new basis provision is important because generally an individual can only be taxed on the value of property that exceeds basis.
In 2002 Congress came close to repealing the estate tax permanently. The Senate rejected the repeal, 54-44, six votes shy of the necessary 60 required for passage. The House voted 256-171 in favor of repeal. Thus the estate law, with its phase out in 2010 and return in 2011, continues to exist.
McDaniel, Paul R., Paul L. Caron and James R. Repetti. Federal Wealth Transfer Taxation: Cases and Materials. 5th ed. New York: Foundation Press, 2003.
Stephens, Richard B., et. al. Federal Estate and Gift Taxation. 8th ed. Valhalla, N.Y.: Warren, Gorham and Lamont, 2002.