General Practice, Solo & Small Firm DivisionTechnology & Practice Guide

American Bar Association
General Practice, Solo, and Small Firm Division

The Compleat Lawyer, Summer 1996, Vol. 13, No. 3

Estate Planning Tax Considerations


Maralee Buttery Vezie is a lawyer at the New York office of Sonnenschein Nath & Rosenthal. Marcie J. Pickard is a lawyer at the Chicago office of Sonnenschein Nath & Rosenthal.

Tax considerations play an important role in the estate planning process. Your primary tax objective is to ensure that your client enjoys the maximum benefits available from the possession and use of property during his or her lifetime, and then is able to transfer the property to selected beneficiaries with a minimum of transfer tax costs.

Currently, federal tax rates on transfers during lifetime and at death range from a low of 37 percent to a high of 60 percent, reaching 49 percent at the $2 million mark. For couples or individuals whose assets, including such items as life insurance and retirement benefits, exceed $600,000, proper estate planning can produce substantial tax savings and increase the amount of property passed on to beneficiaries.

For example, married couples, through the use of trusts and proper titling of assets, can together pass up to $1.2 million to their children or other beneficiaries before any transfer tax is assessed. The estate tax savings from this kind of estate planning is at least $235,000. (See "A Typical Estate Plan for a Married Couple." ) The amount of assets that may be passed on to beneficiaries without transfer tax may be increased even further if an individual regularly makes lifetime gifts.

The federal gift and estate tax system is a "unified" transfer tax system with a single set of tax rates and a unified credit that applies against the gift or estate tax.

The Estate Tax
The federal estate tax is imposed on the "taxable estate." The taxable estate is determined by valuing the "gross estate," which consists of all property owned at death, reduced by certain deductions. The federal estate tax return is due nine months after the date of death, at which time the estate tax liability generally must be paid. Under certain circumstances, it is possible to obtain an extension for filing the return or paying a portion of the estate tax liability.

Gross Estate
The I.R.C. defines the gross estate in an extremely broad and comprehensive manner to consist of all property owned at death, as well as certain property that the I.R.C. artificially attributes to the decedent. The gross estate includes a decedent's home, other real estate, bank accounts, securities, and any other property owned by the decedent. Such property could include, for example, amounts owed to the decedent from a loan made by the decedent to another, salary due from an employer, and the decedent's retirement accounts.

Joint tenancy property held by the decedent and a person other than the decedent's spouse is included in the decedent's gross estate under I.R.C. § 2040, except for any contribution made by the other joint tenant. One-half of joint tenancy property held by the decedent and the decedent's spouse with the right of survivorship generally would also be included in the decedent's gross estate.

In addition, statutory rules include in the gross estate certain property interests in which the decedent had little or no interest at death. For example, the amount of any gift tax paid by the decedent within three years of death is included in the decedent's gross estate under I.R.C. § 2035(c). The value of annuity payments that will be made to any survivor following the decedent's death is included in the decedent's gross estate under I.R.C. § 2039. The value of property that the decedent never owned is included in the gross estate under I.R.C. § 2041 if the owner of such property granted the decedent a "general power of appointment."

Two typical kinds of general powers of appointment are (1) a testamentary power of appointment that the decedent may exercise in favor of anyone, including his or her estate, and (2) the unrestricted right to withdraw the property during life. The general power of appointment may not be so obvious, however. For example, a general power of appointment also exists if the decedent, as trustee of a trust created by someone else, has the unrestricted right to distribute trust property for his or her own benefit for broad purposes such as "welfare" or "comfort." For this reason, use of the proper distribution standards when a beneficiary serves as trustee is critical.

Finally, proceeds from an insurance policy on the decedent's life are included in the decedent's gross estate under I.R.C. § 2042 if either (1) the proceeds are payable to the decedent's estate, or (2) the decedent retained "incidents of ownership" over the policy during his or her lifetime. For example, the decedent is considered to have incidents of ownership over the policy if the decedent had the power to change the beneficiary of the policy.

The Taxable Estate
The taxable estate is determined by subtracting certain permissible deductions from the gross estate. A deduction is allowed for certain obligations existing at death and other expenses necessary in winding up the decedent's affairs. For example, creditors' claims, administrative expenses such as executor and attorney fees, and funeral expenses are deducted from the gross estate. These deductions produce a realistic appraisal of the net amount of property the decedent can pass on at death to designated beneficiaries. For public policy reasons, deductions are also permitted for transfers to charity and transfers to a surviving spouse.

Charitable deductions. For those who are charitably inclined, an unlimited charitable deduction is available for transfers to charity. The deduction is available for outright transfers to charity and transfers to certain trusts. It is possible to create a "split-interest" trust in which both a private person and a charity have an interest. In order to obtain a charitable deduction for a split-interest trust, the trust must comply with the complex requirements applicable to charitable remainder trusts or charitable lead trusts, or fall within certain tightly defined parameters (such as those relating to the gift of a remainder interest in a personal residence or farm).

Marital deduction. A marital deduction is available to shelter from estate tax an unlimited amount of assets distributed to a surviving spouse. Outright transfers of property qualify for the marital deduction, as do transfers to certain kinds of trusts. Two common trusts for which a marital deduction is available are the general power of appointment trust, which permits the spouse to have broad control over the property either during lifetime, at death, or both; and the qualified terminable interest property (QTIP) trust, which may restrict the spouse's control over the trust property. All property for which a marital deduction is available and elected will be included in the estate of the surviving spouse, and may generate estate tax at the surviving spouse's death.

  • General power of appointment trust. A general power of appointment marital trust must provide that all the income be distributed to the surviving spouse. In addition, the surviving spouse must have the unrestricted right to dispose of the principal either during life or at death in favor of anyone, including the surviving spouse or the surviving spouse's estate.
  • QTIP trusts. QTIP trusts are popular because they are flexible, and may accommodate a broad spectrum of dispositive patterns. QTIP trusts are especially useful in second marriage situations, where the client may want to provide for his or her second spouse but also insure that the property ultimately is distributed to children from a prior marriage. QTIP trusts also permit the decedent's executor to fine-tune tax planning after death by electing the extent to which the QTIP trust will qualify for the marital deduction. Doing so is desirable when the surviving spouse dies before the estate tax return for the first spouse's estate is filed. The executor then may elect not to claim the maximum marital deduction for the value of the QTIP trust, and instead, attempt to equalize the value of the two estates in an effort to minimize overall estate taxes.

    A QTIP trust, like a general power of appointment trust, must provide that all income be distributed to the surviving spouse. The remainder of the trust property may be distributed in any manner that the creator of the trust specifies as long as no person other than the surviving spouse receives distributions from the trust during the surviving spouse's lifetime.

    The surviving spouse may receive principal distributions from the trust, but such distributions are not necessary in order to obtain the marital deduction. The surviving spouse may or may not have a power of appointment over the QTIP trust. If the QTIP trust provides the surviving spouse with a power of appointment, the power of appointment may be very limited, or it can be so broad as to exclude only the surviving spouse, the surviving spouse's estate, and the creditors of either.

If a Spouse Is Not a U.S. Citizen
Special rules apply where the surviving spouse is not a U.S. citizen. In order to obtain the benefit of a marital deduction where the surviving spouse is not a U.S. citizen, the property must be distributed to a special trust, known as a qualified domestic trust (QDOT). The requirements for a QDOT are defined in I.R.C. § 2056(d) and 2056A and the accompanying regulations. If the estate plan does not utilize a properly structured QDOT, the executor, through a court reformation, or the surviving spouse may create a QDOT before the due date for the filing of the decedent's estate tax return.

The Unified Credit
Each U.S. citizen and resident has a unified credit of $192,800, which is applied against either gift tax or estate tax that otherwise would be payable. The unified credit protects transfers of up to $600,000 of property, either through lifetime gifts or at death, to anyone.

Credit for State Death Taxes
A credit against the federal estate tax is permitted, in a formulaic amount, for certain state estate tax liability. Many states have a so-called "pick-up" tax, in which the state estate tax that is assessed is equal to the credit available. As a result, the state estate tax does not require payment of additional amounts than what would otherwise be assessed on the federal return. This is because the amount paid to the state offsets federal estate tax that would otherwise be due. Some states, however, impose an independent inheritance tax system that may or may not generate additional taxes at death. State law must be reviewed in each case.

Other Credits
In particular circumstances, certain other credits may be available. As one example, if the decedent owns property that was subject to estate tax during the ten years preceding, or within two years after, the decedent's death, the credit for tax on prior transfers may be available. Lawyers should review the law and the facts at the time to determine whether any such credits are available.

Gift Tax
A gift tax is imposed on certain property transfers made during life that might otherwise be subject to estate tax at death. The gift tax is computed on an annual basis, and a gift tax return must be filed by April 15 of the year following the year in which the taxable gift is made (unless the donor dies prior to July 15 of the year in which the taxable gift is made, in which case the gift tax return is due at the same time as the federal estate tax return). The donor is primarily responsible for paying the gift tax liability; however, the donee is secondarily liable for payment of the gift tax if the donor fails to pay.

Under current law, an individual can give property worth up to $10,000 to an unlimited number of recipients each year free of gift tax. This tax-free amount is called the "annual exclusion." A married donor may make gifts of $20,000 annually per recipient if the donor's spouse consents to "split" the gift (and the spouse has not made any gifts to the recipients in question), in which case a gift tax return must be filed to make the election to split the gift. In order to qualify for the annual exclusion, the gift must be one of a "present interest." An outright transfer of property to a donee is a gift of a present interest. Gifts in trust, however, generally are not gifts of a present interest and do not qualify for this exclusion, unless the trust meets certain requirements, discussed below. In addition to the annual exclusion, a donor may pay tuition or medical expenses directly to a school or health care provider on behalf of anyone without incurring any gift tax liability.

Systematic use of annual exclusion gifts, tuition payments, and medical payments can substantially reduce the amount of property remaining in the gross estate at death that will be subject to estate tax. In addition, gift tax marital and charitable deductions, similar to the estate tax deductions, are available for qualifying transfers of property to a spouse or to charity. Property transfers in excess of the annual exclusion amount that do not qualify as tuition or medical expense payments or for the marital or charitable deduction are taxable gifts and will consume part of the donor's unified credit. Once the entire unified credit has been consumed, the donor incurs gift tax liability for subsequent taxable gifts.

Gifts in Trust
Transfers in trust for a minor qualify as a gift of a present interest if the trust meets certain statutory requirements detailed in I.R.C. § 2503(c). The trust must provide for income and principal distributions to or for the benefit of the minor before age 21, and any remaining trust assets must be distributed to the minor at age 21. As long as the minor has the right to withdraw the trust assets at age 21, even for a limited period of time such as 60 or 90 days, the trust may be extended beyond the minor's twenty-first birthday.

Another technique frequently used to qualify a transfer to a trust as a gift of a present interest is the use of withdrawal rights. This technique permits the beneficiary to withdraw the property transferred to the trust within a limited time period. The beneficiary must be given notice of the withdrawal right and a sufficient time period in which to exercise the right. This method is commonly used in irrevocable life insurance trusts, and may also be used in trusts for minors.

Valuation of Gifts
Generally the value of gifts, like the value of property included in an estate, is the net fair market value of the property being given away. In certain circumstances, however, gifts to a younger family member implicate special valuation rules found in Chapter 14 of I.R.C. § 2701-2704. The attorney should be particularly sensitive to Chapter 14 concerns when clients want to make gifts of business interests (such as corporate stock or partnership interests) to younger family members, when clients establish trusts that benefit both the donor (or someone in the donor's generation) and someone in a younger generation, when two generations join in the purchase of property, and when the client is structuring a buy-sell agreement.

Generation-Skipping Transfer (GST) Tax
In addition to the federal gift and estate tax system, a separate tax is imposed on transfers of property to, or in trust for, a beneficiary who is two or more generations junior to the transferor. Transfers of property to grandchildren, to great-nieces and great-nephews, or to a godchild who is 37 1/2 or more years younger than the transferor, would be subject to the GST tax.

The GST tax applies whether the transfer is an outright gift or bequest, a distribution of income or principal from a trust, or a distribution on termination of a trust. For example, if a client establishes a trust for the benefit of his child, with the remainder to be held in trust for the benefit of his grandchildren following the child's death, the GST tax applies when the child dies. If the client had established a trust that provided for income and principal distributions to his child and grandchildren, any distribution made to a grandchild would result in a GST tax. The GST tax is a flat rate of 55 percent.

Exemptions from GST Tax
Currently, each person has a $1 million GST tax exemption that may be used to shield property transferred during that person's lifetime or at death. In addition, outright gifts qualifying for the $10,000 annual exclusion and medical and tuition payments made directly to the service provider are exempt from GST tax. Gifts in trust qualifying for the annual exclusion are exempt from GST tax only if certain requirements are met. Finally, a special exception (called the "predeceased child" exception) shields from GST tax any property that passes directly from a grandparent to a grandchild if the grandchild's parent who is the child of the grandparent is deceased.

Creating a GST Estate Plan
The objective of GST planning is to maximize the use of the client's $1 million GST exemption. This is done by using trusts. A typical GST estate plan includes three trusts--a Family Trust, a GST-exempt QTIP Marital Trust, and a Non-GST-exempt Marital Trust. The Family Trust is funded with $600,000 (the amount shielded from estate tax by the unified credit), the GST-exempt QTIP Marital Trust is funded with $400,000, and the balance of the decedent's property is allocated to the Non-GST-exempt Marital Trust.

The executor allocates $600,000 of the decedent's $1 million GST exemption to the Family Trust, and $400,000 of the $1 million GST exemption to the GST-exempt QTIP Marital Trust. The executor makes a special election on the estate tax return, known as a "reverse QTIP election" with respect to the GST-exempt QTIP Marital Trust. This election permits the decedent to be treated as the transferor of the property in the GST-exempt QTIP Marital Trust, and allows the executor to allocate the decedent's GST exemption to the GST-exempt QTIP Marital Trust.

At the death of the surviving spouse, the property held in the Family Trust and the GST-exempt QTIP Marital Trust is combined. Any transfers made from this combined pot of GST-exempt assets to grandchildren or more remote descendants will not incur any GST tax, even if the value of this combined pot of assets has appreciated so that it is worth more than the initial $1 million. Distributions to children should be made from the nonexempt assets first, in order to preserve the GST-exempt assets.

Income Tax Issues
Income tax considerations may play a part in the estate planning process. The basis of property for income tax purposes differs depending upon whether the recipient acquires the property by lifetime gift or by bequest, and whether or not the property in question is community property. When property is transferred by gift during lifetime, the basis of the property in the hands of the donee is equal to the lesser of the donor's basis and the fair market value of the property at the date of the gift, increased by a certain portion of the gift tax paid.

By contrast, in common law jurisdictions, when property is transferred at death, the recipient's basis in the property will equal the fair market value of the property at that time. The basis step-up rules at death differ for community property. Therefore, properly characterizing the type of property owned by a decedent is necessary in order to determine the tax basis. The basis of the property is important if the recipient intends to sell the property, because the tax basis will impact the recipient's capital gains tax liability.

Taxes on Retirement Plan Distributions
For many clients, retirement assets constitute a large portion of the estate, and coordinating retirement plan distributions with the client's estate plan is important. Assets held in retirement accounts may be burdened with income tax, estate tax, and possibly an additional 15 percent excise tax. As a result, in many cases, the beneficiaries of the retirement plan assets receive only a small percentage of the retirement plan assets. These issues must be considered in the estate planning process.

Don't Forget the Nontax Issues
Taxes are only one of many issues that must be considered in the estate planning process. Many nontax issues, such as choice of executor, trustee, and guardian, and designation of an agent under a power of attorney for property and for health care, also have a long-lasting effect on the client's estate plan and family.

Sidebar: A Typical Estate Plan for a Married Couple

An estate plan for a married couple is generally designed to minimize overall estate taxes by taking maximum advantage of each person's unified credit and using the marital deduction to defer any estate tax until the death of the surviving spouse. The estate plan typically provides for the creation of a "Family Trust," to which an amount of property that will be shielded from the estate tax by use of the decedent's unified credit will be distributed (currently $600,000), and a "Marital Trust" to hold the balance of the property.

Property held in the Family Trust will not be subject to any estate tax at the death of the surviving spouse. Utilizing both spouses' unified credit therefore allows the couple to transfer $1.2 million without any transfer tax. The Family Trust may be structured in a variety of ways, depending upon your clients' wishes. It may provide for income or principal payments to any one or more of the surviving spouse, descendants, or other beneficiaries. The surviving spouse may be given control over the disposition of the Family Trust through a power of appointment. This power of appointment could be very limited, allowing the surviving spouse to distribute the property only in favor of certain persons, or it could be broad enough to include everyone except the surviving spouse, the surviving spouse's estate, and the creditors of either.

The potential estate tax savings on this two-trust plan is $235,000. This amount represents the tax that would have been assessed on the assets in the Family Trust at the surviving spouse's death if the first spouse to die left all of his or her property to the surviving spouse. Additional estate tax savings are realized by avoiding the estate tax that otherwise would have been assessed on the appreciation on the assets held in the Family Trust from the date of the first spouse's death to the date of the surviving spouse's death. In order to implement this plan, each spouse must have sole ownership of assets worth at least $600,000. Joint tenancy assets will not count for this purpose since such assets pass directly to the survivor by operation of law, and therefore cannot be used to fund the Family Trust.

Copyright (c) 1996 American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

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