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Basics of the Federal Estate Tax
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Introduction
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The U.S. tax system imposes a tax for the "privilege" of making gratuitous transfers of cash or property during life and at death. The federal estate tax is a transfer tax triggered when property is distributed at death. The gift tax (discussed in the June 2004 Newsletter) applies to transfers during life. Both have significant exemptions. Currently, the estate tax affects less than 2% of all estates.
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Estate Tax Exemption
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A U.S. individual is entitled to a lifetime combined estate and gift tax credit (called the "applicable credit"). The current credit amount exempts taxes on taxable estates of $1.5 million or less for tax years 2004 and 2005. The credit amount for taxable gifts made over one's lifetime is capped at $1.0 million. The gift tax permits an additional annual exclusion for present gifts of $11,000 per beneficiary per calendar year (married couples may gift $22,000 per beneficiary per year). For example, a present gift of $20,000 made by an individual results in a taxable gift of $9,000 after the annual exclusion of $11,000 is applied.
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How It Works
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When an individual dies, his or her assets are revalued to fair market value as of the date of death, or in certain instances, 180 days after date of death. The estate tax liability is imposed on the net value of the estate -- the value of all assets, less debts of the decedent including mortgages on property, last illness and funeral expenses, and administrative costs.
For married couples, a marital deduction is permitted for assets transferred outright to a surviving spouse or placed in a special trust called a "Q-TIP" (qualified terminal interest property trust). Once the tax liability is established, the decedent's applicable credit is then applied against the tax liability.
Example: Assume a married couple where no taxable gifts were made in prior years. Husband dies and his share of the estate is revalued at $2.5 million. The estate has debts of $600,000, $300,000 of which is allocated to husband's portion of the estate. In addition, there is another $100,000 for last illness, funeral and administration costs. Husband leaves $1.5 million to his children and the balance ($600,000) to his spouse outright.
| Gross Estate: |
$2,500,000 |
| Deductions: |
($400,000) |
Net estate: |
$2,100,000 |
| Marital Deduction Gift: |
($600,000) |
Taxable Estate: |
$1,500,000 |
| Applicable Credit: |
$1,500,000 |
| Estate tax : |
-0- |
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Unmarried Couples
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Unmarried couples are not entitled to a marital deduction. Therefore, if one partner's estate exceeds the applicable credit, there will be estate taxes paid on the first death. Usually, tax planning for unmarried couples involves equalizing the estates of each to take maximum advantage of the applicable credit available to each individual. This is usually accomplished by making annual gifts or by purchasing assets as equal owners, either through a partnership (or, when appropriate, an S corporation or limited liability company), or as equal co-tenants.
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Basis in Assets
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Because the estate tax revalues assets at the time of the decedent's death, the assets receive a new basis equal to the current fair market value. Thus, the potential tax on appreciated assets is eliminated. In contrast, the recipient of a gift receives the donor's basis in the assets and a later sale of the asset may be subject to income taxes.
Example: Assume Father has a share worth $100 which was purchased for $1.00. If Father sells the stock, he realizes a taxable gain of $99. If Father gifts the stock to daughter, Father has made a $100 gift, but daughter takes Father's $1.00 basis. If daughter sells the stock for $101, she realizes a $100 taxable gain.
In contrast, if Father dies and leaves the stock to daughter, the stock is valued at $100 for estate-tax purposes, but daughter's basis is also $100 (the stock receives a basis step-up to fair market value). A later sale of the stock by daughter for $101, produces only a $1.00 taxable gain.
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Joint Tenancy Property
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Often, married couples own real property as joint tenants. Joint tenancy eliminates probate and property is automatically transferred to a surviving spouse upon the death of their spouse. However, if a husband and wife hold property in joint tenancy, 50% of the asset becomes part of the decedent's estate. As a result, only the decedent's 50% share of the asset will receive a basis step-up at death which could cause a substantial tax liability if the property is then sold by the surviving spouse. This unanticipated result usually occurs when married couples own their home as joint tenants.
For example, a couple purchased a home for $200,000 in joint tenancy and husband dies when the house is worth $1 million; only $500,000 will receive a basis step-up. Wife's basis will remain $100,000 (50% of the $200,000 original basis). A later sale by the spouse for $1.0 million will produce a $400,000 gain. Even if wife's $250,000 exclusion applies to the sale of the residence, she will pay tax on $150,000 of gain not covered by the residence exclusion.
If a non-married couple holds property in joint tenancy, then the entire asset becomes part of the decedent's estate, unless the surviving joint tenant(s) can document their contributions toward the asset. Note: if the entire asset is included in the decedent's estate, the survivor will receive a full basis step-up, which can be an advantage for estates under the applicable exclusion amount because the potential tax on the asset's appreciation is eliminated by the basis step-up.
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Community Property
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In California, married couples may own property as "community property with rights of survivorship" which is essentially the same as joint tenancy, except that the entire property receives a basis step-up upon the death of one spouse. In this case, a later sale by the spouse of $1.0 million would not cause a taxable gain.
In states where assets may be held as community property, titling an asset as community property and transferring it to a revocable living trust will produce the same result: full basis step-up on the death of the first spouse and no probate. Note: Only married couples may own property as community property.
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Income in Respect to a Decedent
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Unfortunately, the revaluation to fair market value only applies to certain assets, which, in general, if sold would generally produce a capital gain or loss. If the beneficiary receives an income-type asset (called "income in respect to a decedent," or IRD), however, there is no basis step-up. IRD includes compensation or commissions owed to the decedent, retirement accounts or plan distributions, dividends, interest, partnership distributions. These assets retain the same character in the hands of the recipient that they would have if paid to the decedent prior to death and the beneficiary usually pays ordinary income taxes on amounts received. The beneficiary, however, is entitled to a deduction, itemized on Schedule A of Form 1040, equal to the pro-rata share of estate taxes paid on the income-producing asset.
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Conclusion
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The vast majority of estates will not pay federal estate taxes. For those estates below the applicable exclusion amount ($1.5 million for 2004 and 2005), transferring assets at death, rather than by gift, will eliminate capital gains taxes on a later sale of the asset. Appreciated property held by a married couple in joint tenancy, such as a residence, investment real estate or brokerage accounts, could cause income tax problems since only 50% of the property will receive a basis step-up.
With unmarried couples, the joint tenancy rules differ - the entire property is treated as belonging to the decedent, except to the extent the survivor can prove contributions. This can be an advantage if the decedent's estate is under the applicable exclusion amount since the surviving tenant will receive a basis step-up equal to the percentage of the asset included in the decedent's estate.
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All contents copyright © 2007 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet(TM) is a trademark of Robert L. Sommers.
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