§ 59  Introduction  [349-350]

 

This chapter introduces the federal system for taxing wealth transfers.  It is not a comprehensive summary.  The goal is to help you identify situations calling for more expertise than you have acquired.

 

The current system began in 1916 with the estate tax and has been evolving ever since.  In 2001, Congress started phasing out the system until there will be no estate and generation-skipping taxes for decedents dying in 2010.  The gift tax will remain, but at lower rates.  In an interesting political game with future Congresses, much of the system is scheduled to be reinstituted in 2011 (at levels that would have been reached before the 2001 amendments).  26 U.S.C.A. §§ 2210 and 2664 (2002).

 

§ 60  A Unified System  [350-353]

 

The unified gift and estate tax system works rather like a large beaker, with a scale printed on the side.  Each time we make a lifetime taxable transfer, we pour a little water into the beaker.  Later additions are assessed at a higher rate, but we do not actually pay any tax until we fill past the threshold Congress has set. Until then we use bits and pieces of our “unified credit” to offset tax we would otherwise owe.  See IRC §§ 2010, 2505.  If we run out of credit by filling the beaker too high, we (or our estates) have to start paying tax.

 

For some examples see Figures 14-1 through 14-3 and the accompanying text.

 

§ 61  The Gift Tax  [353-357]

 

The Internal Revenue Code imposes a tax on any “transfer of property by gift,” while also excluding many gifts of $11,000 (indexed for inflation) or less.  IRC §§ 2501(a)(1) & 2503(b)(2).  As a practical matter, deductions for qualifying gifts to a charity or to a spouse mean that those gifts escape tax.  IRC §§ 2522 & 2523.

 

         A.  What Is a Gift?

 

Deciding whether something is a “gift” for gift tax purposes often involves questions of valuation and of whether a transfer is complete.  Suppose Monica sells Mark her car for $2,000.  If the car is worth $5,000, Monica has made a $3,000 gift.  On the other hand, if the car is worth $1,000, Mark made a $1,000 gift to Monica.  Thus valuation determines both whether there is a gift and the size of that gift.

 

Sometimes donors will give away property, but hold onto some strings.  Then the question is whether the strings are strong enough to mean there was no completed gift.  There is a gift only if the donor has parted with all “dominion and control.”  

 

         B.  The Annual Exclusion

 

To avoid the recordkeeping that would follow if all gifts, including birthday presents, were taxable, IRC § 2503(b) created the annual exclusion, allowing each donor to give $11,000 (indexed to rise with inflation) annually to each donee.  Note how the exclusion encourages wealthy taxpayers to reduce their estates by making lifetime gifts.

 

The annual exclusion applies only to unrestricted rights to the use, possession, or enjoyment of property or its income.  Treas. Reg. § 25.2503-3(b).  However, the Code allows the annual exclusion for future gifts to minors in some circumstances, and lawyers have invented creative devices to use the exclusion.  See Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).

 

§ 62  The Estate Tax  [357-366]

 

         A.  The Gross Estate

 

               1.   Basic Provisions

 

The gross estate is an accounting concept which attributes to a decedent property in the decedent’s probate estate and nonprobate property which benefited the decedent.   One of the most important points to get across to clients is that avoiding probate does not mean avoiding federal estate taxes.  Moreover, married couples need to think in terms of their total wealth.

 

A few basic provisions bring in most of the assets of typical families:

 

·        the estate at death (§ 2033)

·        joint property (§ 2040)

·        life insurance (§ 2042) and

·        retirement benefits (§ 2039).

 

               2.   Some Complications

 

a.      Gifts Within 3 Years of Death

 

IRC § 2035 brings into the gross estate the value of certain gifts made within three years of the decedent’s death, and it brings in the value of taxes paid on all gifts made during that period.  The reason for this rule is to negate—during the three-year period—the tax advantage of making taxable gifts instead of leaving the property to be part of one’s estate.

 

                     b.  Gifts With Retained Interests

 

IRC §§ 2036 to 2038 capture for the gross estate the value of lifetime transfers in which taxpayers retain beneficial interests.  These provisions have generated a great deal of litigation, as taxpayers seek to retain benefits without suffering tax consequences.  In general, the courts have looked at the substance, rather than the form, of the arrangements in question. See United States v. Estate of Grace, 395 U.S. 316 (1969).

 

                     c.  General Powers of Appointment

 

IRC § 2041 brings in property subject to a general power of appointment, with the caveat that if the owner is properly restricted by an ascertainable standard, it is not a general power.  IRC § 2041(b)(1)(A).  Because property subject to a non-general power will not suffer the same fate, lawyers use combinations of these powers to achieve tax and personal planning objectives.

 

               3.   Stepped-Up Basis

 

For income tax purposes, property that transfers at death takes on a new, “stepped-up” basis, its value in the decedent’s gross estate.  IRC § 1014.  As part of the phase-out of the estate tax, the stepped-up basis approach is scheduled to end in 2010.  If the estate tax comes back as scheduled in 2011, a revised “carryover basis” will replace the historic stepped-up approach.

 

         B.  The Marital Deduction

 

Once the value of the gross estate is established, various deductions apply, reducing the gross estate to the “taxable estate.”  For our purposes, the most important deduction is the one for transfers to surviving spouses.  IRC § 2056.  The basic principle is straightforward: the law treats married couples as units, not individuals.  It allows each spouse to give unlimited amounts of property to the other without incurring transfer taxes, so long as the property will be exposed to tax once it leaves the marital unit.  Four types of transfers qualify:

 

·        Outright gifts

·        Trusts giving the surviving spouse a life estate plus a general power of appointment

·        Trusts of  “qualified terminable interest property” (QTIP)

·        Estate trusts.

 

         C.  Using the Unified Credit

 

Because the unified credit is personal to each taxpayer, its value can be lost in large estates if it is not fully utilized.  By making lifetime transfers between each other, or by structuring the estate plan in various ways, married clients can maximize the use of both of their unified credits, in 2006 effectively shielding $2 million from estate tax.

 

               Efficient use of both spouses’ unified credits requires two steps:

 

·        Balance the sizes of both estates during the lifetimes of both spouses

·        Create a “credit shelter trust.”

 

               See Examples 14-1 through 14-4 on text pages 364-366.

 

§ 63  The Generation-Skipping Transfer Tax  [366-367]

 

As part of the phasing-out of the estate tax, the generation-skipping transfer tax (GST) is scheduled for abolition in 2010 (and reintroduction in 2011).  IRC ch. 13. The rules surrounding the GST, and lawyers’ strategies for coping with those rules, are very complex. 

 

The overall goal is to plug holes in the estate tax system in order to tax wealth once in each generation.  The credit shelter trusts noted above are just one variety of a common species: a life estate in trust with considerable benefits, but not so many as to subject the trust to tax.  When trusts line up such life estates in succession, property can escape estate tax for several generations. 

 

To curb this result, the GST taxes transfers to a “skip person,” someone two or more generations below the transferor’s generation.  Consider gifts from Genevieve, to her daughter Peggy, and to Peggy’s son, Troy.  From Genevieve’s perspective, Troy is a skip person.

 

The GST is a wealthy person’s tax.  Each transferor has a $1 million exemption (indexed to increase with inflation), which the transferor can allocate among GST transfers.  IRC § 2631(c).