Estate Planning

The federal estate and gift taxes are transfer taxes on the value of property transferred by lifetime gift (gift tax) or from a decedent's estate (estate tax). Every individual has an applicable credit amount against federal estate and gift tax liability. The applicable credit amount is $345,800 in 2002. This is equivalent to a taxable estate of $1,000,000, which is called the applicable exclusion amount. In 2002, the effective marginal estate and gift tax rates range from 37 to 55 percent on taxable estates that exceed the applicable credit amount, which makes minimizing transfer taxes an important objective.

Estate and gift taxes are cumulative. All taxable lifetime gifts made after 1976 are included in the computation of a decedent's federal estate tax liability. Despite this fact, taxable lifetime gifts have one important advantage over testamentary transfers. Taxable lifetime gifts can freeze the value of appreciating properties as of the date of the gift, so that all future appreciation is removed from the donor's estate. Nevertheless, taxpayers generally shouldn't make lifetime taxable gifts that exceed the applicable exclusion amount. One potential disadvantage of lifetime gifts is that the recipient of a gift must take the donor's income tax basis in the gifted property. The effect is to transfer any income tax gain on the property to the recipient. Unlike gifted property, most inherited property receives an income tax basis equal to the fair market value of the property on the date of the decedent's death.

Some gifts are not subject to a gift tax. The most important type is a present interest gift, which falls under the annual gift tax exclusion amount of $10,000 per recipient (an amount that is indexed annually for inflation). There is no limit to the number of recipients, so large amounts of money or other valuable property interests can be given to friends or family while using the annual exclusion amount to shield the gifts from being taxed. The gift must convey a present interest in the property; that is, it must be available for the immediate use, possession, or enjoyment of the recipient. The annual exclusion can be used in combination with an irrevocable living trust to permanently remove large amounts of potentially taxable value from an estate. Gifts to qualified charitable organizations are tax deductible for either gift or estate tax purposes. Lifetime gifts can also reduce income taxes.

The federal gross estate includes the fair market value of everything actually owned at the date of death, as well as all property interests deemed to have been owned at the date of death. A life insurance policy given away within three years of death is an example of a property interest that is deemed to have been owned by a decedent on the date of death.

The federal taxable estate is computed by first subtracting, from the gross estate, certain allowable deductions such as funeral expenses, administration expenses, debts, taxes, and losses. The value of property left to a surviving spouse or to charity is then deducted, and then the cumulative total of post-1976 lifetime taxable gifts are added. A tentative federal estate tax is computed on this amount, which is called the federal tax base. Any tentative estate tax payable is further reduced by gift taxes payable on post-1976 lifetime taxable gifts and applicable credits, which include the applicable credit amount explained earlier.

Because federal law allows an unlimited marital deduction for property passing to a surviving spouse who is a U.S. citizen, the estate tax on the estate of the first spouse to die can be eliminated completely by leaving the whole estate to the surviving spouse. This simple approach may not work in the long run, however, because it wastes the first decedent spouse's applicable credit amount. The combined tax bill for both estates may be much larger than it would have been if less of the first spouse's estate had passed to the survivor. Estate plans for married couples with a combined estate valued in excess of one spouse's applicable exclusion amount should use a bypass trust or other technique to avoid overqualifying for the marital deduction. A bypass trust, for example, will provide the surviving spouse with the annual income from the trust property and a limited right to invade the corpus, but does not qualify for the marital deduction.

Generation-skipping transfers that do not exceed the generation-skipping transfer tax exemption amount of $1,000,000 per transferor can save money for large taxable estates. These transfers skip over a generation (e.g., from grandparent to grandchild), and thus reduce the incidence of transfer taxation over time. Taxable estates also may benefit from valuation planning. One form of valuation planning involves establishing an entity such as a family limited partnership (FLP), spreading the ownership of the FLP among various family members and restricting the transferability of the interests. With proper planning and implementation, the market value of FLP interests will be subject to considerable discounts.

The Economic Growth and Tax Relief Reconciliation Act of 2001 phases in several changes in federal estate and gift taxation from 2002 through 2010. The changes include increases in applicable credit amounts and reductions in tax rates. The act repeals the estate tax in 2010, but not the gift tax. The most important feature of this new law is that it isn't permanent, which means additional changes in federal estate and gift taxation should be expected.