What Are Estate Taxes?
After you die, your estate may have to pay federal gift and estate tax and federal generation-skipping transfer (GST) tax) (together referred to here as estate taxes) on wealth you have given away by will or by intestacy (if you don't have a will) at death (this wealth is referred to as the gross estate). This is one of the largest potential expenses your estate may have to pay. Prudent planning can reduce this expense and ensure that your property goes to your beneficiaries instead of the government. One way you can accomplish this is to reduce the amount of property that will be subject to estate taxes. Understanding what constitutes the gross estate is the first step in formulating a plan that works for you.
Caution: Your estate may also be subject to state death taxes.
What Is the Gross Estate?
The gross estate refers to all property owned by you (or deemed to be owned by you) at the time of your death. It includes property and property interests — real or personal, tangible or intangible, of any description, wherever located — at the time of your death. Generally, property can be broken into two categories:
- Property you own outright or in trust
- Property you have given away but in which you kept some financial interest or control
How Do You Own Property?
You can own property in different ways:
As a Single Owner
This includes property in which you have sole ownership.
As a Joint Owner With Another Person or Persons
You can hold property in concert with others either by tenancy in common, joint tenancy, tenancy by the entirety, or community property. Your gross estate will include the value of your share of the property. Your share is measured in one of two ways:
- If property is owned as joint tenants or tenants by the entirety with your spouse, your share will be 50 percent of its value regardless of who actually paid for it
- If property is owned as joint tenants with anyone other than your spouse, your share will be measured by the percentage of your contribution to the purchase price
Example(s): In 1968, brothers Mark, Larry, and Charley each chip in and buy a vacation home on the beach. The purchase price is $100,000. Mark pays $50,000 (50 percent), Larry and Charley each pay $25,000 (25 percent each). Mark dies many years later. The fair market value (FMV) of the vacation home on the date of Mark's death is $200,000. Mark's share of the property includable in his gross estate is $100,000 (50 percent of the FMV).
What Property Do You Own Outright?
Property and property interests includable in your gross estate are:
General Property Interests
This is property that you usually think of as being owned by you. Generally, these items correspond to property that is included in your probate estate. This also includes your right to income you have earned but not received prior to death such as deferred compensation, commissions, or bonuses. General property interests include:
- Real estate
- Bank accounts
- Household furniture and appliances
- Art objects and collectibles
- Notes and mortgages held by you
- Outstanding dividends declared but not yet paid
- Post-death salaries, commissions, and bonuses or any other right to collect income
Technical Note: Your spouse has a legal right to some of your property (given either by dower or curtesy, community property, or statute). You can't take this right away from your spouse (although spousal statutory rights may be waived in some cases via a prenuptial agreement or separation agreement). This right prevents you from completely disinheriting your spouse (i.e., you can't make your spouse homeless). This right, however, does not prevent such property from being included in your gross estate (although, if your spouse is a U.S. citizen, the property you transfer to your spouse in a qualified manner is also fully deductible under the unlimited marital deduction).
Certain Annuity Payments and Employee Death Benefits
Generally, annuity payments — the right to receive payments over a period of time — end when you die. If this happens, then no value is includable in your gross estate. However, if there is a right to payments that includes a survivorship element, part of the annuity will be drawn into your gross estate (this may happen under a refund or period-certain annuity). The amount includable depends upon whether the continuing payments are payable to your estate or to a beneficiary. Most employee death benefits are also included in your gross estate.
General Power of Appointment
A power of appointment is the right given to you by the owner of property to decide who receives that property or the right to say who gets it. It is usually given in relation to a trust.
Example(s): James sets up a trust and funds it with $250,000. The terms of the trust provide that, upon his death, his wife, Lillian, is to receive the income interest in the trust for life. James also gives Lillian a general power of appointment, allowing Lillian to decide who gets the trust principal upon her death. James dies. Lillian receives the income interest from the trust for the next five years. Lillian's health begins to fail. Lillian has two sons: Sammy, who is running for mayor, and Billy, who doesn't like to work. Lillian appoints the principal of the trust to Sammy. Lillian dies. Sammy receives the trust principal and is elected mayor.
A general power of appointment includes the right to give the property to yourself, your estate, your creditors, or the creditors of your estate. Because you have the right to declare yourself as the owner of the property, the Internal Revenue Code deems that you are, in fact, the owner of that property. The value of property over which you hold a general power of appointment at the time of your death, as well as certain other property owned over which you had a general power of appointment during your life, is includable in your gross estate.
Certain Property Transferred to You By Your Spouse At Your Spouse's Death
Qualified terminable interest property (QTIP) transferred to you by your spouse at your spouse's death is includable in your gross estate. QTIP is property from which you receive an income stream for life but which passes to another beneficiary upon your death. The QTIP election would have been made by your spouse's personal representative to take advantage of the unlimited marital deduction.
Certain Insurance Proceeds
The value of life insurance proceeds is includable in your gross estate if, either at the time of your death or within the three years prior to your death, the proceeds were payable to your estate, either directly or indirectly, or you owned the policy or you possessed any incidents of ownership. The three-year rule is imposed to discourage you from making this type of gift from your deathbed.
Example(s): In 2017, David took out a life insurance policy naming his estate as the beneficiary. In 2018, David changed the beneficiary and owner to his wife, Lucy. David kept no incidents of ownership. Say that David dies in 2020. The proceeds pass directly to Lucy. The value of the proceeds will be includable in David's gross estate because his interest was transferred within three years of his death.
Technical Note: "Incidents of ownership" is a legal term that means any right to benefit economically or control the asset (e.g., name the beneficiary, surrender the policy, or borrow on its cash value).
Certain Tax Paid and Transfers Within Three Years of Death
Your gross estate must be increased by the amount of gift tax paid by you or your estate on gifts made by you within the three-year period ending on the date of your death. Again, the three-year rule is to discourage you from making gifts — and reducing your estate by the amount of gift tax paid — when death is imminent. Certain other property, which would have been includable in your gross estate under another code section if you held it at death, will also be included in your gross estate if you transfer it within three years of your death. Your gross estate also includes any GST tax you pay on any direct skip gifts you make at death.
What Is Property You Have Given Away But In Which You Kept Some Financial Interest?
The IRS does not allow you to avoid estate tax by transferring title to property to someone else and, at the same time, retaining some rights to the property. With certain exceptions, the value of property is includable in your gross estate if, either at the time of your death or within the three years prior to your death, you had:
- The right to enjoy the property or the income from it (this is a life estate)
Example(s): Hal transfers the title to his home to his sons David and Ricky with the condition that he is allowed to remain living in the home for as long as he lives. Hal dies. The value of the home is includable in Hal's gross estate because he retained an interest in the home and will be treated as if he still owned it.
- The right to regain the property in the event that the person to whom you have transferred the property dies before you do, and this right is worth more than 5 percent of the value of the property (this is a right of reversion)
Example(s): Bill signs over his stock in the power company to Jane for her lifetime. Upon her death, the stock is to revert back to Bill if he is still alive. If Bill is not alive, the stock is to go their son Bart. The value of Bill's right is worth more than 5 percent of the value of the stock. Bill dies. The value of the stock is includable in Bill's gross estate because he retained a right of reversion in the stock at the time of his death.
- The right to alter, amend, revoke, or terminate the gift (this is a right of revocation)
Example(s): Hal transfers some of his property into a revocable trust and names Jane as the beneficiary of the trust. Hal retains the right to alter, amend, revoke, or terminate the trust. Hal dies. The value of the trust is includable in Hal's gross estate because he retained a right of revocation at the time of his death.
Tip: The three-year rule does not apply to revocable trusts.
Tip: You may be able to limit the amount includable in your gross estate to the value of the retained interest through the use of a bona fide sale, a grantor retained annuity trust, a grantor retained unitrust, or an intentionally defective irrevocable trust.
How Do You Value the Property That Is Included In the Gross Estate?
The IRS does not define value but has issued a number of regulations concerning how property is to be valued for estate tax purposes. The general rule is that the value of the gross estate is the FMV on the valuation date, but other valuation methods may apply.
Fair Market Value (FMV)
FMV means the price at which property would change hands between a willing buyer and a willing seller, or what the property would sell for on the open market. This value is based upon the property's highest and best use. In order to avoid disputes with the IRS, care should be taken when establishing FMV. You may want to encourage your personal representative to consult an expert to value certain types of property. You may also want him or her to consult an appraiser for an estimate of value on such items as jewelry, art objects, collectibles, antiques, real estate, and business interests. Your personal representative may need to file a formal appraisal for certain difficult-to-value assets reported on your estate tax return.
Caution: The FMV of real estate is not its assessed value for property tax purposes.
Special Use Valuation
Under certain conditions, your personal representative may elect to value real property used for farming or in a family-owned business (also certain woodlands) based upon its actual use rather than its best use. This special valuation, however, cannot reduce your adjusted gross estate by more than a certain amount ($1,180,00 in 2020, $1,160,000 in 2019). A formal appraisal must be filed with your estate tax return if special use valuation is applied.
Caution: Under the recapture rule, the IRS may recalculate (recapture) the estate tax due using the fair market value method if, within 10 years after your death, the property in question is disposed of or ceases to be used for the originally qualified use.
Valuation of certain types of property such as annuities, life estates, remainders, income interests, and reversions are made using actuarial tables issued by the IRS. In addition, the IRS has issued regulations providing detailed instructions for the valuation of particular types of property including life insurance, U.S. bonds, listed stocks, corporate bonds, mutual funds, closely held corporations, partnership interests, and professional practices.
Valuations of this kind can be complex and, in the case of a family-owned (or closely held) business, may require the application of discounts and premiums. If you own these types of property, you may want to encourage your personal representative to consult an expert who can provide a quality evaluation.
Valuation Date — Date of Death
The valuation date is generally the date of death. A date of death is established by the date in the place of your domicile (where you live), and a date of death value is determined at the instant or moment of death.
Example(s): Sally is a U.S. citizen and resident of Boston. Sally dies while vacationing in Greece on August 16 at 2 A.M., Greek time, which is August 15 in Boston. Sally's date of death is August 15, the date of her death in her domicile, Boston.
Alternate Valuation Date
Your personal representative may elect to use an alternate valuation date if it results in reducing both your gross estate and the sum of any estate tax plus any GST tax that is due. Generally, if this method is elected, all your property is valued either as of the date on which the property is disposed of or six months after death, whichever occurs first.
Tip: This may be advantageous in the event your gross estate decreases in value during the six-month period after your death. Your personal representative can postpone the election of valuation dates up until the date the estate tax return is due (nine months after death, unless an extension is received). This gives your personal representative the opportunity to determine which date will be more advantageous.
What Are Taxable Gifts?
Gift tax is computed on taxable gifts. Gifts can be made either directly (from you to another person) or indirectly (from you to another person for the benefit of a third party).
Is It a Gift?
To determine whether a taxable gift has occurred, the answers to the following questions must be yes.
- Did you freely give property to another individual or organization? Transfers of property that you are legally obligated to make are not gifts. For example, payments you make to support your minor children or payments you make to satisfy a court judgment are not gifts.
- Was the gift complete? You must relinquish control over the property. A taxable gift has not occurred if you retained the power to change or revoke the gift. A gift is complete upon delivery. Completion of delivery varies according to the nature of the gift. For example, a gift of cash is complete when given, a gift of a personal check is complete when paid, a gift of stock is complete on the date the endorsed certificate is delivered, and a gift of real estate is complete when the deed is recorded.
- Was the gift made in exchange for property of lesser value? Ordinarily, you may think of a gift as something you give expecting nothing in return, but gifts also include uneven exchanges of property. The value of the gift is the difference between the exchange.
Example(s): Alec gives his old motorcycle, valued at $3,000, to his younger brother, Adam, in exchange for $500. Alec has made a $2,500 taxable gift.
Caution: An uneven exchange is not a gift if it is a legitimate business sale or just a bad bargain.
Is It a Taxable Gift?
Some types of gifts are exempt from gift and estate tax. They include:
- Tuition paid to an educational institution: You can pay tuition for private school, college, or any other qualified educational institution without incurring gift tax as long as the payment is made directly to the institution.
- Medical expenses paid to the medical care provider: You can pay for someone else's medical bills without incurring gift tax as long as the payment is made directly to the medical care provider.
- Annual gift tax exclusion: You are allowed to exclude from your adjusted gross estate the first $15,000 (in 2019 and 2020) of gifts made to each and every person (or organization), provided that the gift is a present interest in property.
- Gifts to spouses: Although gifts to your spouse are subject to gift tax, they are fully deductible under the unlimited marital deduction as long as your spouse is a U.S. citizen, and provided that the gifts are made in a qualifying manner.
- Gifts to charity: Although gifts to charity are subject to gift tax, they are fully deductible under the charitable deduction, provided that the gifts are made in a qualifying manner.
- Applicable exclusion amount: The applicable exclusion amount effectively exempts the first $11,580,000 (in 2020, $11,400,000 in 2019) plus any deceased spousal unused exclusion amount of gifts you make from gift and estate tax. You must use up your applicable exclusion amount before you become liable for gift tax. Any applicable exclusion amount you use for lifetime gifts effectively reduces the amount that will be available at your death.
How Do You Put a Value on Gifts?
Fair Market Value
Valuation of gifts parallels the valuation of the gross estate in most respects, except the valuation date is the date on which the gift is complete. There is no alternate valuation or special use valuation allowed. There are some situations, however, that are unique to gifts.
The value of a gift of encumbered depends in part upon whether the debt to which the property is subject is nonrecourse debt or recourse debt. A debt is nonrecourse if the only security for the debt is the property purchased with the loaned funds. A debt is recourse if the creditor may seek to satisfy the debt from other sources, such as from the debtor personally.
Generally, the value of encumbered property by a nonrecourse debt is the net value of the property (FMV of the property less the amount of the obligation). If the donor of the property continues to make payments on a debt for which he is no longer liable, each payment is an additional gift. If the debt is recourse and the donee (the person you give to) has the right to recover the debt from you, the value of the initial gift may be the FMV, unreduced by the amount of the debt.
Example(s): Michael transfers a $100,000 building subject to a $40,000 nonrecourse debt to his son Shaun. Because the debt is nonrecourse and may only be satisfied out of the transferred property, the value of the gift is the FMV less the debt, or $60,000.
Example(s): If Michael had instead transferred a $100,000 building subject to a $40,000 recourse debt on which Michael remained personally liable, and Shaun had the right to compel Michael to pay the debt, the value of the gift would be the full $100,000 FMV.
Interest-Free or Below-Market Loans
Giving a loan interest free or below the market rate is a taxable gift. The value is determined by computing the forgone interest. The forgone interest is the difference between the interest computed using the applicable federal rate and the interest computed using the stated rate. How this value is determined depends upon whether the loan is a term loan or a demand loan.
Gifts to Charity
Some gifts to charity may be valued at less than FMV depending on the type of gift and the type of charity. Practically, however, this does not matter for gift tax purposes because the value assigned to such gifts is also deductible under the charitable deduction.
Direct Skip Gifts
The amount of GST tax that you pay on a direct skip gift is an additional gift that is also subject to gift tax.
This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.
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