Taxation of Estates and Gifts
When someone dies, they leave an estate, which (maybe) has a tax levied against it.
The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.
Cemetary plots are only included to the extent not "designed for the interment of the decedent and the members of his family." 26 U.S.C. § 20.2033–1(b). They are consumed.
Bonds are included at their market value, not their payout amount. Just because they are exempt from income tax, does not mean that they are exempt from estate tax.
If money is only accessible after so many years, the amount must be discounted according to § 7520 Table B.
If money is only accessible after someone's death, the amount must be multiplied by the corresponding "remainder" value in § 7520 Table S.
§§ 2038 & 2033 discount; § 2036 does not.
The estate will file the return on income that comes in while the estate still owns it. If income still is being paid after such rights are distributed, the beneficiaries must pay the income tax on them.
It is ideal for the estate to earn as little income as possible, because high tax rates kick in very quickly for them. 26 U.S.C. § 1(e).
This applies even if it is a contractual agreement to pay a survivor, and it does not go through the estate.
Dividends, unlike rent and interest, do not accrue until they are "declared and recorded."
- Declaring a dividend means that the dividend is announced.
- The date a dividend is recorded is the date that the stock must be owned to receive the dividend.
26 U.S.C. § 2036 says that gross estates also include the value of property where the decedent transferred part of his interest but retained part of it for his life, where the portion was not sold for "adequate and full consideration."
- "For life", for a period not ascertainable without reference to his life, or for a period which does not end before he actually dies
If the right was only to the income from part of the property, only that part will be included in the gross estate.
If the right was only for an annuity, only that part of the property the income from which is necessary to maintain paying that annuity will be included. (Divide the annuity amount by the interest rate to find the corpus.)
If the child buys a remainder interest at the rates in Table S, nothing is included in the gross estate from the annuity under 26 U.S.C. § 2036. (Although the value of the consideration will be under 26 U.S.C. § 2033 if the decedent does not consume it. (And at expected interest rates, it will reach the same value as the gross estate would have included if it was not sold.))
- To find the value of a life estate or remainder, use Table S. (Although you will need an interest rate.)
If the decedent actually dies before the period ends and transfers a remaining interest, the full amount is still included by § 2036 and nothing is included by § 2033.
Unlike §§ 2033 & 2038, § 2036 does not discount. Include the entire value of the retained property at the date of the death.
Elements of § 2036
- Decedent owned property, transferred part, and kept part;
- The retained interest is a "life-like interest";
- The transferred interest was not sold "bona fide" for "adequate and full consideration;"
- The property interest retained by the decedent is either:
- possession of non-income producing property or income from income producing property, or
- the right, either alone or in conjuction with any person, to designate the persons who shall possess the property or its income; and
- The amount included in the decedent's gross estate is the value, as of the decedent's date of death, of the property transferred during life to which the retained interest relates.
The right to designate income does not include a power over the transferred property itself which "does not affect the enjoyment of the income received or earned during the decedent's life."
- If the income from principal is already being transferred to someone during the decedent's life, the right to transfer the principal to that person is not included.
Property is only included under 26 U.S.C. § 2036 if the decedent still had the "string" at the date of his date. However, 26 U.S.C. § 2035 will capture interests transferred away within 3 years of one's death.
This amount must be discounted to the amount of time after decedent's death that it will be until the remainder transfers by multiplying it by the corresponding "remainder" value in 26 U.S.C. § 7520 Table S or B.
A condition being immaterial means that the condition does not matter. The result is the same whether the condition is present or not.
|Condition||Immaterial under Section 2036||Immaterial under Section 2038|
|Joint Power, i.e., act of D and another person is necessary to exercise the power||✔ 26 CFR § 20.2036-1(b)(3) text(i)||✔ 26 CFR § 20.2038-1(a)|
|Capacity, i.e., D holds power as a fiduciary, like a trustee||✔ 26 CFR § 20.2036-1(b)(3) text(ii)||✔ 26 CFR § 20.2038-1(a)|
|Contingency beyond D’s control is condition precedent to D’s having the power||✔ 26 CFR § 20.2036-1(b)(3) text(iii)||❌ 26 CFR § 20.2038-1(b)|
|Contingency within D’s control is condition precedent to D’s having the power||✔ Implied from 26 CFR § 20.2036-1(b)(3) text(iii)||✔ Implied from 26 CFR § 20.2038-1(b)|
|Power relates only to time and manner of enjoyment, e.g. income and remainder beneficiary is the same person||❌ Implied from 26 CFR § 20.2036-1(b)(3) text(iii)||✔|
Money may be included in both §§ 2036 & 2038, so just pick the larger of the two values.
There is, in fact, significant overlap between § 2036 and § 2038. If a decedent retains the right to designate who gets the income generally, usually both with apply (and 2036 will be the one that matters). However, if the decedent only has the power to change who gets the income after he dies, it only falls under § 2038, not § 2036, and they therefore get the discounting. (Which makes sense. You only are taxed on the remainder because all you can control is the remainder.)
- This is not the case if it's the remainder after someone else dies—then it all is included under § 2036.
- Unless the other actually dies first, then I think nothing's included.
Gross estates include the fair market value of property to the extent of the interest held in, except for the portion paid for by the other party for full and accurate consideration versus how much was contributed by the decedent. 26 U.S.C. § 2040(a).
- Capital in the initial purpose and in later improvements are counted together.
- If a mortgage was used to pay for the property, it also includes any mortgage payments paid and half of any outstanding mortgage at the time of death.
- If a second mortgage is taken and partially used to pay off the first mortgage, the portion of the second mortgage used to pay off the first is includable the same way. (If $100,000 is taken out, $60k of it is used to pay off the first mortgage, the surviving partner pays off $10k, and then the other partner dies, $33k will be includable. [($60k / $100k) × ($10k + ($90k / 2)) = $33,000])
If only owned by a husband and wife, the value is is always split 50/50. 26 U.S.C. § 2040(b).
- Especially if planning for a non-portability regime, you do not want this with valuable because you cannot necessarily apportion it well. A better type of property ownership would be better.
- Although, the applicable exclusion amount would probably go down too if non-portability returned, so you might want to get it over with with the higher amount.
When a joint interest is gifted to a spouse, that half of the giftor's basis is transferred along with the property. 26 U.S.C. § 1041(b)(2). When the giftor then dies, a surviving joint tenant with right of survivorship will take a fair market value basis in the decedent's estate. 26 U.S.C. § 1014(a)(1).
- E.g., so if wife buys property for $10, she puts it in joint interest with husband, the value goes up to $20, and she dies, the husband's basis will be $25. $10 will be included in the gross estate.
- It does not matter if spouses paid different amounts for property if their interests are equal.
- If community property, the whole fair market value is the basis.
The basis of gifts is the basis that the giftor had. 26 U.S.C. § 1015. So if a parent buys property worth $10 and gives half to a child, both will get a basis of $5. The child's basis would also be increased by the parent's half's fair market value if the parent dies.
If two joint tenants who are not married die at the same time, the property is treated half as if the decedent survived and half as if he did not. (Usually, this will mean half is included as a joint interest under 26 U.S.C. § 2040 (Although this will be $0 if the decedent did not pay anything.) and half is included under 26 U.S.C. § 2033.)
26 U.S.C. § 2042(2) says if there is a life insurance policy on your life but the beneficiary is someone else and you have the power to exercise power over who gets the benefits of it, the amount that you can control is includable in your estate.
If bank takes out insurance on the decedent for his mortgage, that policy is includable.
- However, if it can be shown that someone other than the decedent paid premiums, that portion of the life insurance is not includable. Liebmann v. Hassett.
The actual current value of a life insurance policy is called "the interpolated terminal reserve value." (We won't have to know how to calculate it (The life insurance company would do it.), but know the term.)
There are no inclusions with irrevocable life insurance trusts (ILITs), where cash is given to the trust sufficient to generate interest equal to the premiums on the policy, which will pay to the desired persons. These are very common and optimal.
26 U.S.C. § 2035 does not apply if the property was bought for "adequate and full consideration". 26 U.S.C. § 2035(d). This usually means fair market value, but if one transfers a retained life estate, it is the full value of the retained and then transferred property at the time of the decedent's death minus the consideration because it really means the amount that would have been included in the estate tax had the transfer not happened. Allen.
If less than adequate and full consideration is paid, the rest of the consideration still must be included, but the amount paid can be excluded under 26 U.S.C. § 2043 so as to avoid double-tax.
If property is transferred from a revocable trust, it is treated like the decedent transferred it directly himself.
Annuities are included in one's gross estate if the annuity is receivable by someone because he survived the decedent and if the annuity was payable to the decedent (or he had the right to receive the annuity) alone or with another for decedent's life, a period not ascertainable without reference to his death, or for a period which does not end before his death. 26 U.S.C. § 2039(a).
In a joint and survivor annuity, both people will satisfy 26 U.S.C. § 2039(a) if they die first because they both have a contractual right to the payments. The annuity to the potential survivor is deducted from that potential survivor's estate by 26 U.S.C. § 2039(b) instead, whether or not he actually survives. The second person to die is not included because of 26 U.S.C. § 2033.
To value an annuity, use the formula: annualPayment × annuityFactor = value
- Use the annuity factors from the 7520 tables to solve for whatever part you need.
- e.g., $8,000 per month at 70 years old: $96,000 × 8.4988 = value → value = $815,884.80
To value an annuity with a right of survivorship, use the formula: annuityFactor = (1 − remainderFactor) ÷ interestRate
To find the exact term (assuming a straight line) for a remainder factor, find the two closest terms in Table B and use the formula: term = termLower + (interestRateHigher − interestRateExact) ÷ ((interestRateHigher − interestRateLower) ÷ 1)
- Basic slope stuff. Would need calculus to find the exact term.
A power of appointment is a right to order the transfer of property owned by someone else.
A donor gives power to a donee who can exercise the power to appoint the appointive property to the permissive appointees. When he does so, the person given the property is the appointee.
A donee can release a power by a writing evidencing such intention.
A donee can also disclaim a power (usually must be within 9 months) to be treated as if he never had the power of appointment.
A general power of appointment is one that has one of the following as permissive appointees:
- The decedent
- The decedent's estate
- The decedent's creditors
- The decedent's estate's creditors
Except the following are not general powers of appointment:
- A power to consume, invade, or appropriate property for the benefit of the decedent that is limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent. 26 U.S.C. § 2041(b)(1)(A).
- A power exercisable by the decedent only in conjunction with the creator of the power. 26 U.S.C. § 2041(b)(1)(C)(i).
- A power exercisable by the decedent only in conjunction with a person having a substantial interest in the property subject to the power, which is adverse to the exercise of the power in favor of the decedent. 26 U.S.C. § 2041(b)(1)(C)(ii).
A substantial adverse interest is one where one has a not insignificant proportion of the power "after the decedent's death and may exercise it at that time in favor of himself, his estate, his creditors, or the creditors of his estate." 26 CFR § 20.2041-3(c)(2).
Like with § 2038, it does matter whether the power is subject to a contingency beyond the decedent's control. § 2041 is only triggered when the decedent has the power at the time of his death. If it was subject to a condition not satisfied, nothing is included.
If the decedent exercises or releases property, treat it as if he transferred the property instead. 26 U.S.C. § 2514(b).
- Thus, check §§ 2035–2038 to see if transferring the property would make it includable under 26 U.S.C. § 2041(a)(2). (26 U.S.C. § 2035 is the most likely, especially if nothing is retained.)
If decedent has a joint general power of appointment with another person for whom it is also a general power of appointment, the estate tax inclusion is the aliquot share—the amount divided by how many people have a general power of appointment. 500-Rev. Rule 76-503.
If a power of appointment requires the consent of another, it goes away when that other person dies first. It cannot be exercised because he is already dead.
Trusts are also subject to state law.
If in a UTC state, trustees must have an ascertainable standard for giving himself benefits. UTC § 814(b)(1).
Under the UTC, "ascertainable standard" means "a standard relating to an individual’s health, education, support, or maintenance within the meaning of [26 U.S.C. § 2041(b)(1)(A)]".
If the amount one has power over is greater than the limit, the percentage of the trust principle he had power over that is greater than the limit when it lapsed is included.
- E.g., if someone has power over $75,000 of a million dollar trust when it lapsed, he would have to include 2.5% of the trust when he dies (within 3 years) because $75,000 is 7.5% of $1 million. If it then became worth $2 million before he died, $50,000 would have to be included under 26 U.S.C. § 2041.
Currently, the applicable exclusion amount is $10,000,000 plus the cost-of-living adjustment (so $11,400,000 in 2019). 26 U.S.C. § 2010(c)(3)(B)–(C). This allows an exclusion of that amount for everyone. (This exclusion is accomplished through the applicable credit amount.)
- Funeral expenses
- Administration expenses
- Claims against the estate
- Unpaid mortgages
- See 26 CFR § 20.2053-7.
So, the exclusion amount is currently about $22,000,000 per couple. It is currently fully portable and it does not matter how it is planned.
Planning under a non-portability regime
Since the non-portability rule is still used and may be returned to, it is still important to learn.
In order to maximize each spouse's applicable exclusion amount, the amount of the first spouse to die's applicable exclusion amount (~$11,000,000) is placed in a trust that does not qualify for the marital deduction.
This "bypass trust" fully exhausts the decedent's applicable exclusion amount, but is not included in the surviving spouse's estate because it only gives the right to all income from the trust and the power of appointment for her "health, education, support, or maintenance." (I.e., not a general power of appointment)
Any remaining property is given directly to the surviving spouse or to a trust that does qualify for the marital deduction. This "pecuniary marital bequest" will then use up the surviving spouse's applicable exclusion amount when she dies.
- The way this is drafted is with a pecuniary marital bequest formula provision.
A pecuniary marital bequest formula provision says to give one's spouse "the least amount necessary to obtain a marital deduction sufficient to reduce the federal estate tax payable to the lowest possible amount."
- This will give all the property in the estate minus the applicable exclusion amount.
To qualify for the marital deduction:
- The property interest must be included in the decedent spouse's gross estate.
- An interest must pass from the decedent spouse to the surviving spouse.
- The interest must not be a terminable interest.
- The surviving spouse must be a US citizen.
In general, if a surviving spouse gets an interest that will terminate or fail by the lapse of time or by the occurrence or non-occurrence of an event or contingency and a third party will possess it afterwards because of a transfer from the decedent, the deceased spouse's estate cannot take a marital deduction. 26 U.S.C. § 2056(b).
- Basically, you can't deduct a life estate or term of years given to a spouse.
If the interest can only terminate within six months after the decedent's death and the termination does not occur, this is not considered an interest which will terminate or fail on the death of such spouse. 26 U.S.C. § 2056(b)(3).
- This is made for simultaneous death provisions.
- The surviving spouse must be entitled to all the income from the interest for life.
- The income must be payable at least annually.
- The surviving spouse must have the power to appoint the entire interest to herself or her estate.
- The surviving spouse's power to appoint must be exercisable alone and in all events.
- Nobody has a power to appoint any part of the property to someone other than the surviving spouse.
Life insurance or annuity with power of appointment in surviving spouse is essentially the same thing as a life estate with power of appointment in surviving spouse except obviously it is life insurance or an annuity instead. 26 U.S.C. § 2056(b)(6).
Qualified terminable interest property is property which passes from the decedent, in which the surviving spouse has a qualifying income interest for life, paid at least annually, and which is elected under 26 U.S.C. § 2044. 26 U.S.C. § 2056(b)(7).