Federal estate taxes are imposed on the transfer of wealth at death. The calculation of the estate tax is based on the value of a decedent’s “gross estate.” The gross estate can be loosely defined as the value of all property in which the decedent had an interest at the time of death (plus certain other statutorily mandated items).
Who is Subject to the Estate Tax?
The estate tax is imposed on the taxable estate of every decedent who is either a citizen or resident of the United States. The determination of the amount of estate tax due is, like most taxes, based on the computation of a taxable amount multiplied by a progressive tax rate. In all cases where estate tax is due, a Form 706, Estate Tax Return, must be filed. The estate tax return must be filed within nine months after the decedent’s death, although an extension of an additional six months is generally granted upon the filing of an application for extension.
Inclusions in the Gross Estate
Property interests included in the gross estate are usually valued at fair market value on the date of death. Some of the special rules regarding the inclusion of property in a decedent’s gross estate are as follows:
Property Owned Outright. This is the simplest and most obvious category of items included in the gross estate. It comprises all property that a decedent owned individually and outright.
Jointly-Held Property. If joint property is held with rights of survivorship between husband and wife, then one-half of the value of such joint property is included in the gross estate of the first joint tenant to die and the other one-half is excluded from the gross estate. If joint property is held with right of survivorship between persons who are not husband and wife (such as parent-child or brother-sister), then the entire value of any joint property will be included in the estate of the first joint tenant to die unless the estate can affirmatively prove that the surviving joint tenant supplied some, or all, of the money used to purchase the joint property.
Life Insurance: The proceeds of any life insurance on the decedent’s life is included in the gross estate if (a) the policy proceeds are payable directly or indirectly to the decedent’s estate; or (b) the decedent held any incident of ownership in the policy, such as the right to change the beneficiary, surrender or cancel the policy, or borrow against the property.
Marital Deduction Planning
Of the various estate tax deductions, clearly the most significant is the unlimited marital deduction which provides an estate tax deduction for property left to a surviving spouse. There are two basic prerequisites of the unlimited marital deduction:
An Interest Must Pass to the Surviving Spouse. A marital bequest must be to a legally recognized spouse. A bequest to a divorced or deceased spouse will not warrant a marital deduction. The surviving spouse must also be a citizen of the United States.
The Interest Must be a Deductible Property Interest. Mere passing of property from a decedent to a surviving spouse alone is not enough to warrant a deduction. An interest is deductible only to the extent such interest is included in determining the value of the gross estate. The reason for this rule is simple — if an item is not included in the gross estate, its passing should not qualify for a deduction.
Estate Tax Unified Credit
Each U.S. citizen may exempt from estate taxation asset transfers up to approximately $5,400,000 (2017). Recently, the estate tax law was changed so that a decedent’s estate tax exemption may be applied against lifetime gifts and after death bequests by will or trust. For married couples, any part of the $5.4 million credit which is not used by the first spouse to die may be carried over to the surviving spouse. This is referred to as The carried over credit is referred to as the Deceases Spousal Unused Exclusion (“DSUE”). To take advantage of the DSUE the law requires the surviving spouse to file a federal estate tax return, Form 706, upon the death of the first spouse and properly elect DSUE on the Form 706. Preparing a Form 706 is complicated even for smaller estates and families should expect to pay significant legal and accounting fees.
Income Tax Planning
Estate tax planning has income tax consequences to the extent the gross estate includes assets that have appreciated in value. Assets left to a surviving spouse after application of the deceased spouse’s unified credit acquire a stepped up value basis to the date of the first spouse’s death. If these assets are sold either by the surviving spouse or later by children there the assets will be subject to capital gains tax (about 20%) on the appreciation from the date the assets were purchased by the deceased spouse; there is no step up in tax basis. The surviving spouse does not pay income tax on assets acquired from their spouse when the assets are shielded from estate tax using the marital deduction. When children inherit those same assets upon the second spouses’s death the children’s income tax basis is “stepped up” to the asset values on the date of the surviving spouse’s death. Assets For couples with estates under the $5.4 million credit it makes sense to pass all assets to the surviving spouse. However, if assets continue to appreciate to the point where the surviving spouse’s assets increase in value above the combined tax credit (approximately $11 million) then the excess value will be subject to estate tax at approximately 40%.