Estate Tax Planning Concepts in a Nutshell

An inheritance tax is levied on each beneficiary’s share, an estate tax is levied on the estate. There is a federal estate tax but no federal inheritance tax. However, six states levy an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

The estate tax is tax inclusive because the money in the estate is burdened with the tax bill. The beneficiaries keep the estate minus the applicable tax. The gift tax is tax exclusive because what the gift recipient gets does not get taxed, because the taxes were paid by the donor.

The illustration below shows how this affects percentage terms but not the actual amount.

Before 1982 gifts within three years of death was included in the gross estate, but not since then. This is because gift and estate taxes were unified. Still, the amount if these gifts within 3 years of death are added to the gross estate but solely to push the estate higher up in the progressive tax rate schedule. If gift tax was paid on these gifts, they should have been reported, and credit is given on the estate tax return for the previously paid gift tax. This avoids double taxation, i.e., paying taxes once on the gift and again as part of the estate.

Gifts are valued in the estate tax computation at the earlier, date of gift value, and not at the date of death value.

Special tax elections are available for individuals whose estate consists of a large interest in farms or other closely held businesses. There are specific percentage requirements to qualify. In order to prevent gaming of the system, the three-year rule prevents individuals from raising the percentage by gifting other types of property shortly (3 years) before their demise. These will be treated as part of the gross estate for the eligibility determination only.
See: Utilization of Special Estate Tax Provisions for Family-Owned Farms and Closely Held Businesses

Transfers made by the decedent during their lifetime may be included in the gross estate if the decedent retained control of the transferred property. Control could consist of retaining the right to receive the income from the property, possess or enjoy the property, or designate, either alone or with another, who will receive the property. The same applies to gift transfers in which the decedent retains a reversionary interest, and any transfer of property in which their decedent retains, in trust or otherwise, the right to alter, amend, revoke or terminate the transferee’s possession and enjoyment of the property.

Annuities and retirement benefits such as IRAs, 401(k) plans, etc., are included in the gross estate.

If payments are received as a periodic payment then the present value of the income right of the beneficiary is included in the gross estate of the decedent. This computation is made according to the regularly published Internal Revenue Service valuation tables.

If the joint interest is held by spouses, such property is treated as if one half were owned by each spouse, irrespective of the actual consideration furnished.

For all individuals other than spouses, the gross estate includes the entire value of all jointly owned property, not merely the decedent’s proportionate interest. The full value of the property can be reduced, however, by the actual consideration furnished by the survivor.

The gross estate includes only the decedent’s proportionate part of the gifted or inherited joint property.

Only one half of the income tax basis in the property receives a stepped up basis to the date of death value of the property.

Powers of appointment allow the holder to appoint property held in trust to whom the holder wishes. Generally, a power of appointment is a device through which owners of properties reserve to themselves or to others their power to designate a transferee of a property or the shares or interest a transferee may receive. See also: Powers of Appointment – An incredibly flexible estate planning tool and Powers of Appointment (Sega).

A general power of appointment (GPOA) refers to a power that may be exercisable in favor of the power holder, the holder’s estate, the holder’s creditors, or the creditors or their estate. It therefore also permits the powerholder to appoint himself or herself as the recipient of the property. General Powers are conceptually those that allow the donee to use the appointive property as if it was his or her own. A GPOA causes inclusion in the holder’s taxable estate. As a result, the assets subject to the power get a step-up (or -down) in basis at the death of the holder. All powers that are not general powers of appointment are, by default, limited powers of appointment. See also: Powers of Appointment – An incredibly flexible estate planning tool

Powers of appointment are called limited or special powers of appointment  as long as they may not be exercised in favor of the holder, the holder’s estate, or the creditors of either. In contrast to General Powers of Appointment, the assets subject to a Limited Powers of Appointment (LPOA) are not taxed to the power holder. LPOAs can add much flexibility to estate planning. A LPOA can allow a beneficiary to direct where the assets will go at their death at a time when the the beneficiary has much more information for that decision. As stated, a LPOA does not cause inclusion in the holder’s taxable estate and does not cause a step-up (or -down) in basis. See also: Powers of Appointment – An incredibly flexible estate planning tool

The gross estate includes the full value of any life insurance on the decedent’s life, the proceeds of which are payable to the decedent’s estate or any other beneficiary, provided the decedent possessed at death any incidents of ownership in the life insurance policy.

The entire proceeds of an insurance policy on the life of the decedent will be includible in the gross estate if the policy and the incidents of ownership were transferred by the decedent to another within three years of his or her death.

Life insurance is a good asset to give because of the tax basis. Life insurance typically has low cash value in relation to the proceeds payable at death. Pay attention to the the three year rule: If the incidents of ownership of the life insurance were transferred by the decedent to another within three years of his or her death, the entire proceeds of an insurance policy on the life of the decedent will still be includible in the gross estate. Term life insurance is a particularly attractive gift because it has no cash value and thus its gift create no gift tax. The gift tax consequences of giving life insurance with a cash flow can be lessened if the decedent borrows the policies cash value before making the gift.

The “Adjusted Gross Estate” itself is used only for determining the percentage requirements for section 303 redemption or section 6166 extension to pay the estate tax. The taxable estate is the gross estate minus all deductions, not only those allowable for the calculation of the adjusted gross estate, see below.

“For purposes of this section, the term, “adjusted gross estate” means the value of the gross estate reduced by the sum of the amounts allowable as a deduction under section 2053 or 2054. Such sum shall be determined on the basis of the facts and circumstances in existence on the date (including extensions) for filing the return of tax imposed by section 2001 (or, if earlier, the date on which such return is filed).”

The following may be deducted from the gross estate: The actual expenses incurred for funeral expenses, costs of administration, debts and unpaid mortgages of the decedent, and losses incurred during the estate administration. Administrative cost is a broad category of estate settlement related costs and includes such expenses as executor, legal, and accounting expenses; appraisal and brokerage fees, and court costs. Any debts including accrued but unpaid taxes, owed by the decedent at the time of death that are enforceable under state law are deductible. Mortgages are likewise deductible, provided their decedent’s interest in the underlying property is included in the estate.

The gist of a section 303 redemption is that redemption of the shareholder’s stock of a closely held business is not treated as dividend (i.e., ordinary income) but as a capital transaction. With Section 303, a qualifying redemption would be taxable only to the extent that the amount of the redemption exceeded the estate or beneficiary’s basis. This makes it easier to pay the costs associated with the decedent’s death.

See also: Section 303 Stock Redemption Buy-Sell Agreement

The first deduction is allowed for the value of any property passing to public, charitable , end religious organizations. The second deduction is the marital deduction which is allowed for qualified property passing from the decedent to his or her surviving spouse.

1. The property must pass from the decedent to the surviving spouse
2. The survivor must be the decedent’s spouse at the time of death
3. The property must pass outright to the surviving spouse, unless the qualified terminable interest property (QTIP) election applies.

The Qualified Terminable Interest Property Election provides an important exception to the requirement that the property must pass outright to the surviving spouse to take advantage of the marital deduction. Because of this QTIP election, such property may still qualify for the marital deduction if certain requirements are met. See here: What is a qualified terminable interest property (QTIP) trust?

The adding back is required because of the unification of the estate and gift taxes. Any gifts made by the decedent after 1976 that are not includable in the gross estate are added to the taxable estate. The amount added back is the date of gift value of the gift, less any applicable gift tax exclusion, marital deduction, and charitable deduction. This is termed the adjusted taxable gift. The federal estate tax is then computed. The tax is then reduced by the gift tax previously paid on the added back gifts.

Exemptions: They are prespecified. Certain types of income, such as portions of retirement income, some academic scholarships, and income from municipal bonds, are tax exempt, meaning that they are not included as part of a filer’s taxable income.

Deductions: They depend on your use of income. A tax deduction is a specific expense that a taxpayer has incurred and can subtract from their taxable income.

Exemptions and deductions decrease your tax base. The tax savings are therefore variable and depend on your average tax rate. In contrast, tax credits lower your tax bill dollar for dollar.

Credits: In contrast to exemptions and deductions, which reduce a filer’s taxable income, credits directly reduce a filer’s tax liability — that is, the amount of tax a filer owes. Taxpayers subtract their credits from the tax they would otherwise owe to determine their final tax liability. That means that a $100 tax credit reduces the amount of tax a filer owes by a maximum of $100.

Source: Policy Basics: Tax Exemptions, Deductions, and Credits

1. Unified credit. In 2022 it exempts from the state taxation an estate up to $12,060,000. The amount of the exemption is further increased for the amount of the unused exclusion of a deceased spouse. This concept is called portability in the estate tax laws (2011, permanent in 2013).
2. Federal estate tax paid on a prior estate.
3. Foreign death tax that is paid.

The tax credit is available if the property was subject to the federal estate tax in a prior decedent’s estate, the property passes to the present decedent, and the property is included in the present decedent’s estate.
The credit is reduced but 20% at 2-year intervals beginning with the third year after the date of death of the first decedent.