Taxation of Estates and Gifts

outline

Class Info

Law School: Liberty University School of Law

Course ID: LAW 615

Term: Fall 2019

Instructor: Dean Todd

My Grade Earned: B+

Books Used
  • Selected Federal Taxation Statutes and Regulations by Daniel J. Lathrope
Section List
Section #Section TopicTab ColorPage #
691Income in Respect of a DecedentOrange568
2010(c)Exclusion AmountBlue728
2031Gross EstateGreen733
2033Gross Estate ValueGreen743
2035Three YearsGreen___
2036Retained Life EstateGreen744
2037Transfers on DeathGreen___
2038Revocable TransfersGreen745
2039AnnuitiesGreen___
2040Joint InterestsGreen746
2042Life InsuranceGreen___
2043Selling Too CheapGreen___
6018Estate Tax ReturnsBlue821
20.2033–1(b)GravesGreen1626
20.2031–7(d)Value of AnnuitiesGreen1644
20.2036–1(b)(3)Designating PeopleGreen1645
20.2036–1(c)(2)(i)Retained AnnuitiesGreen1646
20.2040–1(a)(i)Joint InterestsGreen1654
7520 Table SLife Annuities TableGreen1852
7520 Table BFixed Term Annuities TableGreen1856
Estate Tax

When someone dies, they leave an estate, which (maybe) has a tax levied against it.

Gross Estate
26 U.S.C. § 2033

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.

Discount

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.

Income in Respect of a Decedent

Income in respect of a decedent (money earned before death but not paid before death) is not subject to income tax for the normal cash basis taxpayer. This income tax leak is patched by IRD.

Income in respect of a decedent is taxable income for his estate or beneficiary (whoever receives it). 26 U.S.C. § 691(a)(1).

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.

Royalties for earnings after death are not IRD, but just income for the estate/beneficiary, so they are still included on income tax, but no longer estate tax.

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.

IRD is also included in the gross estate under 26 U.S.C. § 2031 & 26 U.S.C. § 2033.

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.
Retained Life Estate

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
  1. Decedent owned property, transferred part, and kept part;
  2. The retained interest is a "life-like interest";
    Life-Like Interest

    A "life-like interest" is one which is kept for:

    1. decedent's life,
    2. a period ascertainable only with reference to decedent's death, or
    3. any period which does not in fact end before decedent's death.
  3. The transferred interest was not sold "bona fide" for "adequate and full consideration;"
  4. The property interest retained by the decedent is either:
    1. possession of non-income producing property or income from income producing property, or
    2. the right, either alone or in conjuction with any person, to designate the persons who shall possess the property or its income; and
  5. 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.

26 U.S.C. § 2036 is only intended to include the powers over the property that actually affect it while the decedent is alive. It 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. (See, however, [26 U.S.C. § 2038] for the inclusion of property in the gross estate on account of such a power.) 26 CFR § 20.2036-1(b)(3). E.g., remainders. It has to be sure to not affect him during his life.

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.

Revocable Transfer

A decedent's gross estate includes any property given away but still subject to the decedent's power to alter, amend, revoke, or terminate. 26 U.S.C. § 2038.

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.

Immaterial

A condition being immaterial means that the condition does not matter. The result is the same whether the condition is present or not.

Immaterial Table
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.
Joint Interest

Generally, gross estates include the fair market value of property to the extent of the interest held. Thus, if two people own property as tenants in common, each's share will be included according to the percentage ownership, regardless of what each actually paid.

For jointly-purchased, non-spousal joint tenants with rights of survivorship, even though they always own equal shares, the percentage paid for by the other party for full and accurate consideration will be excluded. 26 U.S.C. § 2040(a).

  • Inclusion Amount = value × ( 1 − others' contributions total cost of acquisition )
  • 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.)

Life Insurance

26 U.S.C. § 2042(1) says if you are the insured and your estate receives the benefit of that, it is includable in the gross estate.

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.

Life insurance whose ownership is transferred within three years of death is includable under 26 U.S.C. § 2035.

  • 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.
    • E.g., with a $100,000 policy that D pays for for nine years, then his sister pays for for one year, then D dies, $90,000 is includable.
    • This is very similar to what happens with joint interests in 26 U.S.C. § 2040.

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.

Anything transferred within three years of one's death that would have been included under §§ 2036, 2037, 2038, or 2042 if he had kept it is included in his gross estate. 26 U.S.C. § 2035.

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.

Annuity

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).

Annuities are taxed under 26 U.S.C. § 72, which provides for an exclusion ratio of the investment paid divided by the expected return. (So exclude that ratio of each payment.)

When an annuity-holder dies without recovering all his basis, he can deduct that amount on his final tax return. 26 U.S.C. § 72(b)(3).

The ratio of the annuity that was paid by someone other than the decedent or his employer can not be included. 26 U.S.C. § 2039(b).

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.
SCIN

A self-cancelling installment note is a promissory note sold by a beneficiary to his benefactor which is forgiven by the benefactor upon his death.

This high-end strategy theoretically evades estate tax, but the IRS will challenge it by asking how the self-cancelling was priced into the sale.

Power of Appointment

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.

Power of appointment can be contingent or not, joint or not, and limited in time or not (in which case, the power lapses).

If the decedent is a donee of general powers of appointment, the appointive property is included in his estate tax. 26 U.S.C. § 2041(a)(2).

General Power of Appointment

A general power of appointment is one that has one of the following as permissive appointees:

  1. The decedent
  2. The decedent's estate
  3. The decedent's creditors
  4. The decedent's estate's creditors

Except the following are not general powers of appointment:

  1. 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).
  2. A power exercisable by the decedent only in conjunction with the creator of the power. 26 U.S.C. § 2041(b)(1)(C)(i).
    • Except on the flip side, it is then includable in the creator's estate tax if he predeceases under 26 U.S.C. § 2038. (And § 2036 could also apply.)
  3. 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).
Substantial Adverse Interest

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).

If one's interest does not pass on death to his fellow joint donees, they do not have substantial adverse interests. 26 CFR § 20.2041-3(c)(3).

Aliquot Rule

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.

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.

Property required to be included in the decedent's gross estate because of the power of appointment is also included in the estate's income tax. 26 U.S.C. § 1014(b)(9).

If the decedent exercises or releases property, treat it as if he transferred the property instead. 26 U.S.C. § 2514(b).

Aliquot Rule

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)]".

Lapse

A lapse of power of appointment is generally considered a release. The exception is if it is a lapse of a 5-or-5 power. 26 U.S.C. § 2041(b)(2).

5-or-5 Power

A 5-or-5 power is one where a person can appoint to anyone the greater of $5,000 or 5% of the principle. 26 U.S.C. § 2041(b)(2).

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.
Taxable Estate

Estate taxes are not actually imposed on the gross estate. They are imposed on the taxable estate. 26 U.S.C. § 2001.

The taxable estate is the gross estate minus the allowable estate tax deductions. 26 U.S.C. § 2051.

Exclusion

26 U.S.C. 2010 gives every decedent a credit for the estate taxes on the applicable exclusion amount, thereby excluding it.

Applicable Exclusion Amount

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.)

  • Read problems carefully! They may have an older year and thus a lower exclusion amount.

The applicable exclusion amount is increased by the deceased spousal unused exclusion amount.

Deduction

26 U.S.C. § 2053(a) provides for four estate tax deductions:

  1. Funeral expenses
  2. Administration expenses
  3. Claims against the estate
    • See 26 CFR § 20.2053-4.
    • Pending lawsuits against the estate usually cannot be deducted, but it is possible to file a protective claim with the IRS which will let one get a refund if it is paid.
    • Promises or agreements can only deducted if contracted for in exchange for full and adequate consideration. 26 U.S.C. § 2053(c)(1)(A).
  4. Unpaid mortgages
Marital Deduction

26 U.S.C. § 2056(a) allows a deduction for the value of any property interest that passes to the surviving spouse that was included in determining the value of the gross estate.

Deceased Spousal Unused Exclusion Amount

26 U.S.C. § 2010 allows a decedent's last deceased spouse's unused exclusion amount to be added to the decedent's applicable exclusion amount.

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.

AB Trust Flowchart
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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.

To qualify for the marital deduction:

  1. The property interest must be included in the decedent spouse's gross estate.
  2. An interest must pass from the decedent spouse to the surviving spouse.
  3. The interest must not be a terminable interest.
  4. The surviving spouse must be a US citizen.
Terminable Interest Rule

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.
Life Estate with Power of Appointment in Surviving Spouse

LEPOA is an exception to the terminable interest rule for life estates laid out in 26 U.S.C. § 2056(b)(5). It has five requirements:

  1. The surviving spouse must be entitled to all the income from the interest for life.
  2. The income must be payable at least annually.
  3. The surviving spouse must have the power to appoint the entire interest to herself or her estate.
  4. The surviving spouse's power to appoint must be exercisable alone and in all events.
  5. 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

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

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).

Qualifying Income Interest for Life

The surviving spouse has a qualifying income interest for life if she's entitled to all the income from the property or has a usufruct and if no one can appoint anyone else. 26 U.S.C. § 2056(b)(7)(B)(ii).

The estate tax is levied on the taxable estate plus the adjusted taxable gifts minus the aggregate amount of gift tax paid. 26 U.S.C. § 2001(b).

  • Past gifts to irrevocable trusts only concern the amounts at the time of gifting. The current value of the trust is irrelevant.

Although 26 U.S.C. § 2001(c) gives a progressive estate tax rate, this is meaningless as one only pays estate tax when over a certain amount, so it will always be a 40% tax.

  • However, its progressiveness means you do have to subtract $54,200 from the result to account for it being lower than 40% for the first million.
Gift Tax

26 U.S.C. § 2501 imposes a gift tax on "transfers of property by gift."

Taxable Gifts

Start with the total amount of gifts made during the year. 26 U.S.C. § 25.2511-2.

Then exclude all medical and educational expenses. 26 U.S.C. § 2503(e).

  • Tuition of medical expenses must be paid to the providers, not the beneficiary.

Then exclude the annual exclusion amount. 26 U.S.C. § 2503(b).

Then deduct marital gifts. 26 U.S.C. § 2523.

Then deduct charitable gifts. 26 U.S.C. § 2522.

Then add the GST tax payable. 26 U.S.C. § 2515.

The resulting amount is "taxable gifts".

Then calculate the tax due by:

  1. Combining the amount of taxable gifts in the current year with the taxable gifts of all prior years.
  2. Calculate how much the tax would be on that amount.
  3. Calculate how much the tax would be on just the prior years'.
  4. Subtract the amounts.
  5. Subtract the available gift tax credit.

The remaining amount is the gift tax due.

The gift tax applies to real, personal, and intangible property. 26 U.S.C. § 2511.

The value of the gift is what a willing buyer would pay a willing seller. 26 U.S.C. § 25.2512-1.

  • Any inadequate consideration paid by the donee can be deducted from the value.

Married couples can split gifts to treat them as being made half by each, but consent must be signified by Tax Day (usually done on the gift tax return).

  • Not needed in community property states for obvious reasons
Annual Exclusion

The first $10,000 (adjusted for inflation, so $15,000 in 2019) of gifts can be excluded per donee per year. 26 U.S.C. § 2503(b)(1).

Gifts of future interests are denied the annual exclusion. Only present interests qualify. 26 U.S.C. § 2503(b)(1).

Income from a discretionary trust does not qualify for the annual exclusion because the beneficiaries thereof do not have a present interest then. 26 CFR § 25.2503-3(c)

  • If the settlor retains the right to withhold the money, each individual distribution uses the annual exclusion for that year. 26 CFR § 25.2511-2(b)–(c).
  • If the trustee has the discretion to decide the portions among the beneficiaries, they still have no present interest. The entire amount will be included in that year's taxable gifts, and there're no annual exclusions in the distribution years.
    • It's still irrevocable, so you still have to pay the taxes. It's just discretionary so you don't get the deductions.
Marital Gift

Outright gifts to spouses qualify for a marital exception. 26 U.S.C. § 2523(a).

Gifts of terminable interests do not qualify. 26 U.S.C. § 2523(b).

  • If the spouse's interest is terminable—don't get confused by others' terminable interests.

Future interests are OK.

Generation-Skipping Transfer

A generation-skipping transfer, where one gives to his grandchild, is subject to a GST tax. 26 U.S.C. § 2601.

A GST is a taxable distribution, taxable termination, or direct skip.

Direct Skip

A direct skip is a transfer subject to a gift or estate tax that is made to a skip person.

  • This includes distributions from revocable trusts where the settlor has to include them as gifts.
Direct Skip Nontaxable Gift

A transfer excluded from gift tax by the annual exclusion amount or by medical/education exclusions is also excluded from the GST tax. 26 U.S.C. § 2642(c).

DSNG Separate Share Rule

A transfer to trust does not qualify as a DSNG however unless it is distributable only to that individual during his life and the trust assets will be includable in that individual's federal gross estate if he dies before the trust terminates. 26 U.S.C. § 2542(c)(2)(A)–(B).

Just because a transfer to trust is eligible for for the annual exclusion amount does not mean that it is a DSNG.

Skip Person

A skip person is an individual two or more generations below the the transferor. 26 U.S.C. § 2613(a)(1).

  • If someone is not a descendent of the transferor's grandparents, he is assigned two generations below the transferor if he was born more than 37½ years after the transferor was. 26 U.S.C. § 2651(d).
    • However, if one has been married at any time to the transferor or a non-skip relative of the transferor, he is assigned the same generation as the transferor and is not a skip person. 26 U.S.C. § 2651(c).
    • Or if one is the descendant of a transferor's spouse's or former spouse's grandparents, he is not a skip person if he is not two generations or more below the spouse. 26 U.S.C. § 2651(c).

A trust also counts as a skip person if all interests are held by skip people. 26 U.S.C. § 2613(a)(2).

Entities are treated as being owned by the individuals owning them. 26 U.S.C. § 2651(f)(2).

Interest

A skip person has an interest in a trust if he can receive current distributions of income or principal. 26 U.S.C. § 2612(c).

This is different that what is a "present interest" for annual exclusion purposes.

There are three types of taxed GSTs:

  1. Direct Skip

    A direct skip is a transfer subject to a gift or estate tax that is made to a skip person.

    • This includes distributions from revocable trusts where the settlor has to include them as gifts.
    Direct Skip Nontaxable Gift

    A transfer excluded from gift tax by the annual exclusion amount or by medical/education exclusions is also excluded from the GST tax. 26 U.S.C. § 2642(c).

    DSNG Separate Share Rule

    A transfer to trust does not qualify as a DSNG however unless it is distributable only to that individual during his life and the trust assets will be includable in that individual's federal gross estate if he dies before the trust terminates. 26 U.S.C. § 2542(c)(2)(A)–(B).

    Just because a transfer to trust is eligible for for the annual exclusion amount does not mean that it is a DSNG.

  2. Taxable Termination

    A termination of an interest in a trust is a taxable termination if it leaves only skip persons as beneficiaries of the trust.

    A generation-skipping transfer tax is imposed when a taxable termination occurs.

  3. Taxable Distribution

    A taxable distribution is a distribution from a trust to a skip person that is not a taxable termination or a direct skip. 26 U.S.C. § 2612(b).

    E.g., distributions from an irrevocable trust.

GSTs are always taxed at 40%. 26 U.S.C. § 2641; 26 U.S.C. § 2001(c).

GST taxes are paid out of the property constituting the GST unless explicitly stated otherwise. 26 U.S.C. § 2603(b).

If you only know the amount including taxes with direct skips, divide the amount by 1.4 to find the after-tax amount given, and multiply that by .4 to find the amount of the GST tax.

Gift tax has to be paid on GST tax amounts.

  • Gift tax does not have to be paid on gift tax amounts. So don't keep adding it up forever, just once.
Applicable Credit Amount

Every person has a lifetime application credit amount (made to effect the applicable exclusion amount.) It is $4,505,800 (~40% of the AEA) in 2019.

  • Read problems carefully! They may have an older year and thus a lower credit amount.

Every gift over the annual exclusion reduces the applicable credit amount. Then the same remaining applicable credit amount is applied against the estate tax at death.

This credit also includes a deceased spouse's credit from the deceased spousal unused exclusion amount.

Gift taxes are more efficient than estate taxes. The gross estate includes the money used to pay the estate tax, but gift taxes are paid out of other money.

Trust

26 U.S.C. subchapter J categorizes trusts as simple trusts, complex trusts, and grantor trusts.

All estates are complex trusts. 26 CFR § 1.651(a)-5.

Grantor Trust

A grantor trust is a non-exclusive type of trust where the grantor retains or gives to his spouse one or more of the powers or interests in 26 U.S.C. §§ 673–678. These are basically "strings" of control over the property like having discretion over distributing income or having AART powers.

Every trust is also either a simple trust or complex trust.

Simple Trust

A simple trust is a trust that requires the distribution of all fiduciary accounting income, that does not make a charitable deduction, and that does not distribute principal.

Complex Trust

A complex trust is any trust that is not a simple trust.

Trusts required to distribute all income (all simple trusts and some complex trusts) have a deduction in lieu of a personal exemption of $300; other trusts get a $100 deduction. Estates get $600.

The tax differences between simple and complex trusts are inconsequential. So while a trust's status must be declared on the return, they can always just be analyzed as a complex trust.

Fiduciary Accounting Income

Fiduciary account income is largely determined by state law, but it includes both tax-exempt and normal income (including interest) and excludes capital gains and losses. 26 U.S.C. § 643(b).

  • Capital gains and losses are just allocated as an increase in principal, not as actual income. UPIA § 404.
    • Some other expenses may be treated like this too, and some are half included. UPIA § 502.
Distributable Net Income

The distributable net income is the taxable income of the trust (from 26 U.S.C. § 61, including capital gains and excluding tax-exempt interest at first) with some adjustments made. 26 U.S.C. § 643(a).

  1. Subtract the "distributions deduction". 26 U.S.C. § 643(a)(1).
  2. Add back the personal exemption substitute deduction from 26 U.S.C. § 642(b). 26 U.S.C. § 643(a)(2).
    • I.e., it's not allowed.
  3. Subtract net capital gains allocated to principal. 26 U.S.C. § 643(a)(3).
  4. Add tax-exempt interest. 26 U.S.C. § 643(a)(5).
Allocating Distributable Net Income

After determining DNI, it must be allocated among the distributions.

First, indirect expenses of the trust must be segregated pro rata between taxable income and tax-exempt income. The differences after subtracting direct expenses and these portions of indirect expenses from classes' gross incomes are the net amount of DNI for the classes (which should add back up to the total DNI). You really only care about the percentages here though.

Second, DNI must be allocated among the distributions according to a tier list:

  1. Required distributions. 26 U.S.C. § 662(a)(1).
  2. All other distributions. 26 U.S.C. § 662(a)(2).
  • All DNI and charitable deductions are first allocated proportionally among the tier 1 distribution beneficiaries.
  • If the DNI is greater, what's left over is then likewise allocated among the tier 2 distribution beneficiaries.
  • If there is still DNI left over, the DNI is allocated to the trust, and it will be taxed for it.

Then each person has income according to the DNI allocated to him, classified as according to the percentages that the income was classified as.

Distributions Deduction

To calculate the distributions deduction:

  1. Take the lesser of:
  2. Subtract the net tax-exempt income (TEI−Direct TEI Expenses−Allocated Indirect Expenses)
65-Day Rule
26 U.S.C. § 663(b)(1)

If within the first 65 days of any taxable year of an estate or a trust, an amount is properly paid or credited, such amount shall be considered paid or credited on the last day of the preceding taxable year.

You must elect to do so though.

Trust Taxable Income

A trust's taxable income is its gross income from 26 U.S.C. § 61 (including capital gains and excluding tax-exempt interest) minus its expenses and charitable deductions (allocable to non-tax-exempt income (26 U.S.C. § 265.)), distributions deduction, and the personal exemption substitute deduction.