The federal estate tax is no secret. It affects less than 5 percent of decedents' estates, primarily because most die with taxable estates of less than $2 million (exempt from tax in 2008; $3.5 million in 2009) or transfer their estate assets to a spouse or charity (not taxable).
The federal gift tax is mostly unknown or ignored, however. Donor gifts of $12,000 or less to each recipient are exempt, gifts to a spouse or charity are not taxable, and total gifts to all donees of $1 million are exempt from taxation.
Everyone should be aware of both taxes, however, and plan to minimize or avoid both as much as possible.
Following is a brief summary for advisors dealing with anyone who could be subject to either tax.
Gift tax overview
The gift tax is a transfer tax that the person making the gift (the donor) pays if the gift exceeds the annual exclusion ($12,000) to the recipient (the donee) and the gift, as well as all prior gifts, exceed the lifetime exempt amount ($1 million) for the donor. The gift must be complete, which requires that a donor be competent enough to make a gift, a donee accept it, and the property be fully transferred. The tax is based on the fair market value at the date of the gift. A gift is not complete until the donee has received the property. For example, establishing a joint savings account with a child is not a gift for tax purposes until the child withdraws from the account in which the parent made the deposit. Likewise, setting up a revocable trust of which a child is the beneficiary is not a taxable gift until the child receives money from the trust.
The gift tax return is filed by April 15 in the year following any gift that exceeds the annual exclusion.
The gift tax rate begins at 18 percent and tops out at 45 percent.
o Annual exclusion: The first $12,000 made outright to any one person each calendar year is excluded from the gift tax. A husband and wife can make a joint gift and double the exclusion to $24,000, no matter who owned the property or money given. The annual exclusion can also apply to certain trusts established for minors; generally, the minor must be entitled to the gifted amount by age 21.
o Exempt gifts: Gifts to a spouse, either outright or in a qualified spousal trust, are exempt from the gift tax. Gifts to charities are exempt and may be deducted on the donor's 1040. Gifts to pay for another person's medical expenses or college tuition are exempt.
o Valuation of gift: The gift is valued at its fair market value at the date of the gift (which is the price that a ready and able buyer and seller would determine). For example, if a mother gives her daughter land that originally cost $10,000 but is worth $20,000 at the date of the gift, then $20,000 is the value for gift tax purposes. An interest-free or below-market-rate interest loan may be considered a gift of the foregone interest. For example, if a father gives his son a loan of $300,000 at 0 percent interest when the federal funds rate is 5 percent, then the gift is the amount of unpaid (deemed) interest (i.e., $300,000 x .05 = $15,000). The father may have to report the deemed interest as income.
o Gift tax computation: The gift tax is computed based on statutory rates; a credit is then applied against the tax.
The gift tax credit is $345,800 (equivalent to $1 million in taxable gifts, thus the reference to an exemption of $1 million). Any credit used will reduce any estate tax credit (which in 2008 is $780,800, which is the equivalent of $2 million in taxable estate). The remaining credit can apply to future taxable gifts. Since the gift tax credit is part of the unified credit applied to the gift tax and estate tax, the gift tax credit used has the effect of reducing the credit available for estate tax.
Estate tax overview
The federal estate tax, like the gift tax, is a tax on the transfer of property from the decedent to the heirs or beneficiaries of the estate. The tax begins for estates over $2 million (in 2006-08). Property transferred to a spouse or charity will be exempt from the tax. The tax rate for taxable estates is 45 percent (in 2008). Prior taxable gifts reduce the estate tax credit ($780,800, which equals the exemption equivalent of $2 million).
The exemption increases to $3.5 million in 2009, with no tax in 2010. Thereafter, the tax reverts to the $1 million exemption equivalent ($345,800 credit).
The federal estate tax is due within nine months of the decedent's death.
What's in an estate?
The fair market value of the decedent's gross estate consists of:
o Property solely owned (personal or real estate in decedent's name alone)
o Transfers with a retained life estate (a father deeds his house to his son but retains the life estate)
o Revocable transfers (revocable living trust)
o Certain transfers made within three years (life insurance policy ownership transferred)
o Survivorship annuities (a mother buys an annuity for the joint lives of her and her son and then dies, leaving the balance to the son)
o Jointly owned interest (a father adds his daughter's name to the deed to his house and the father dies)
o General power of appointment (the decedent's will gives the recipient the power to transfer property to self or creditors)
o Life insurance owned by decedent (a decedent dies, owning policy payable to her son)
What's in a taxable estate?
The taxable estate is the gross estate minus certain deductions, such as:
o Expenses (probate fees, funeral)
o Debts of decedent (mortgage, credit card)
o Taxes (decedent's income tax for income before death, real estate taxes, state death tax)
o Losses from casualty or theft during probate (tornado destroys estate property)
o Transfers to charity (will provides $10,000 to United Way)
o Transfers to spouse, outright or through qualified terminable interest property (QTIP). Property owned by both the decedent and their spouse is included in the gross estate at one-half of the fair market value, which represents the decedent's share. That one-half is then deducted as a marital deduction because the spouse, as surviving co-owner, received the entire asset. QTIP is usually in the form of a spousal trust from which the surviving spouse receives all the annual income, and the amount in the trust after the spouse's death is subject to the estate tax.
Estate tax credits
The unified credit is available to reduce the tentative estate tax. For 2008, the credit is $780,800; for 2009, the credit is $1,455,800.
For example, if the taxable estate is $3,500,001, then the tentative estate tax is $1,455,800. If the taxable estate exceeds the available unified credit and other applicable credits, then an estate tax is due.
Generation-skipping tax
The generation-skipping transfer tax is designed to tax transfers that skip the next generation, such as when they are transferred to grandchildren.
For example, say a mother dies in 2009, leaving $4 million to her grandchildren rather than her children, who are financially well-off. By doing this, she avoids burdening the children's gross estate with that amount. The mother's estate will incur an additional tax for that skip; the exemption is $2 million for the years 2006-08 and $3.5 million in 2009. Any amount over and above the exemption is taxed at the highest estate tax (45 percent in 2009).
As you can see, the estate and gift tax realm is complex and multi-faceted. There is even more to learn than we can cover here, but the payoff can be handsome when you're able to advise your clients on the intricacies of their liabilities and rights.
Stephen M. Maple is associate professor of business at University of Indianapolis and a private attorney. He is the author of the third edition of "The Complete Idiot's Guide to Wills and Estates." He can be reached at smaple@uindy.edu.
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