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VII. TAX ISSUES

A. What is included in your taxable estate for federal purposes?
B. Federal Gift and Estate Tax law in a nutshell
C. A simple living Trust will not save any tax
D. Lifetime gifts vs. transfers at death

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VII. TAX ISSUES

A. What is included in your taxable estate for federal purposes?

In a word, everything. Remember, the size of the probate estate has nothing to do with the size of the federal taxable estate. The 2001 estate tax law increased the amount of each person's estate that can be sheltered from tax, but it did NOT change what is included in that estate.

For 2004 and 2005, if the value of a person's, or married couple's combined federal taxable estate reaches $1.5 million, the need for estate tax planning is triggered - unless death can be postponed a few years. This "trigger amount" is set to reach $3.5 million over the next few years after that.

The taxable estate includes:
- All property interests owned by you, or by a Trust you control outright, or by a Trust to which you have any significant "strings attached."

- Qualified retirement plan proceeds. These were not part of the taxable estate under old law. Now such proceeds are includable, but a full or partial exclusion may be available to some persons who retired no later than 1984.

- Life insurance proceeds, if the policy is owned by the decedent or payable to the estate.

Part of the confusion associated with discussions on this topic can be cleared if one recognizes that we are dealing with at least two different taxes: Federal estate and gift tax is our main focus here, but the federal income tax consequences of any options you consider are important, too. Life insurance is a good example. Life policy proceeds are almost always received by the beneficiary with no income tax due. But, as stated, if the insured person owns the policy, those proceeds will be subject to estate tax when he dies. Additionally, you might have a state inheritance or estate tax to consider, as well.

State inheritance or estate taxes ("death" taxes) have historically been of much less significance in planning than federal tax - for one thing, state rates are much lower than the federal rates. Additionally, many states have used a "painless" system that charges the estate whatever is the maximum amount that can be subtracted directly from the federal tax tab, if any - so there's no extra tax hit. (That amount is called the "state death tax credit.")

But federal estate tax changes have been decreasing the amount of the state death tax credit allowed.  The credit will be eliminated entirely in 2005. The likely loss of revenue to the states is huge. Will they sacrifice that revenue, or restructure their death tax systems to take it back? Planners should be alert to the issue of state taxes in the years ahead.

B. Federal Gift and Estate Tax law in a nutshell

Prior to the tax law changes taking effect in 2002, ALL transfers of money or property (outright, or by Will or Trust) - during life or at death - were subject to a single, Federal Unified Gift and Estate Tax system. Since the estate tax - but not the gift tax - is set for repeal after 2009, however, it may no longer make sense to talk about a "unified" system. Fortunately, the new law still allows some significant transfers to be excluded from the estate tax, while it lasts, and the gift tax, which we are stuck with. In addition to those exclusions, presented later, each person has a general exemption, or shelter against the federal gift and estate tax.

For many years, that sheltered amount had been $600,000, but it began increasing for persons who died in 1998.  For those  dying in 2006 - 2008 the "standard" sheltered amount is $2.0 million. Pursuant to the Economic Growth and Tax Relief Reconciliation Act of 2001, the "exemption amount" - the amount sheltered from estate tax, but not from gift tax is supposed to continue to increase through 2009, after which the estate tax itself is scheduled for elimination. (Let's see if that actually happens!!)

Meanwhile, the amount sheltered from gift tax was increased to $1 million per person in 2002, but does not rise further. Till then, the maximum rate on the taxable portion of gifts and estates will be decreased, as well. These changes are set forth in the table below:

Calendar year	Estate Tax Exemption (per person)	Highest estate and gift tax rates
2002	$1 million	50%
2003	$1 million	49%
2004	$1.5 million	48%
2005	$1.5 million	47%
2006	$2 million	46%
2007	$2 million	45%
2008	$2 million	45%
2009	$3.5 million	45%
2010	N/A - Estate tax repealed (but gift tax NOT repealed)	Gift tax rate = top individual income tax rate

IMPORTANT NOTES:

- Remember, the tax on lifetime gifts is NOT set for repeal, and the increase in the sheltered amount is much less than what is now scheduled for transfers of property occurring after death. The exemption for lifetime gifts - each person's sheltered amount - previously has been equal to whatever the shelter was that year for the estate tax. But the shelter for lifetime gifts went up to $1 million in 2002 and will stay there, under current law.

- There is a "self-repeal" feature in the 2001 tax law. All the benefits and breaks automatically end after 2010. Unless further legislation is passed, we'll then revert to the 2001 status quo!

The law prior to the 2001 changes called for an eventual increase in the gift and estate tax shelter to $1 million, so most observers feel that figure will prevail after 2010 if the estate tax repeal is allowed to expire and no new tax relief is enacted.

Since congressional predictions of huge and everlasting budget surpluses have proved to be ridiculous, this appears to be a distinct possibility. Therefore, large estate owners, for the greatest chance of obtaining the maximal estate tax benefit, should plan to die during 2010. The estate tax will have been fully repealed on the last day of 2009, and the repeal won't be repealed till the end of 2010!

Lifetime gifts, if they do not qualify as one of the tax exclusions below, begin to "use up" the above-listed exemption (the tax shelter). Whatever portion of the $2.0 million (for 2006 - 2008) that is not used for lifetime gifts is available to protect your estate at death. So, assuming you have not used any of the shelter by making non-excludable lifetime gifts, no federal tax is due on the first $2.0 million of your estate. But then, rates begin at 37%, and go to 50% (to be reduced to 45%, in steps, until elimination of the estate tax after 2009.

Other exclusions from federal gift and estate tax:

$12,000 annual exclusion per donor for gifts. This amount had previously been $10,000, then $11,000, but was adjusted for inflation (as it will be in the future), effective January 1, 2006. Cash and/or property worth up to $12,000 can be given without tax consequences to each of an unlimited number of recipients. ($24,000 per year, per recipient, if both spouses give.)

These gifts do not count against the $1.0 million shelter against federal gift tax or the $2.0 million shelter against federal estate tax. They require no paperwork, and are income tax-free (as are all gifts) to the recipient.

To qualify, the gift to each donee must be outright - a present right to spend or use the property with no strings attached - not a promise of a future benefit. This requirement means that most gifts in trust do not qualify. (The exceptions are presented later.)

Illustration: A husband and wife sell a house to their son for $50,000, when it is worth $120,000. A $70,000 gift has been made ($120,000 - $50,000). The parents elect to split it, so that both of their $12,000 annual gift tax exclusions can be used. This $24,000 combined exclusion results in a taxable gift of $46,000 to the son ($70,000 - $24,000). A federal gift tax return should be filed, but no tax is now due. Instead, because the gift has been split, each parent uses $23,000 of his/her $1 million lifetime gift tax shelter to "protect" the gift from all tax. The son pays no tax on the gift. (True gifts of any size are always free from federal income tax.)

Assuming this has been their only taxable gift to anyone, each of the parents will then have a shelter of $977,000 remaining to shield future lifetime gifts from federal gift tax ($1.0 million - $23,000). The gift tax return that has been filed with no payment allows IRS to keep track.  (Note that the $23,000 gift also uses up part of each parent's $2.0 million shelter from federal estate tax.)

TIP: The above situation - where parents want to help their children buy a house - is common. A better way to handle it might be to sell the house to the child at full price. Then, each year the parents can make a $24,000 gift, in the form of debt forgiveness. By doing it gradually, the parents can take advantage of each of their annual $12,000 exclusions (using the 2006 figure for the annual gift tax exclusion), and not waste any of their two $1 million shelters.

Unlimited marital deduction from gift and estate tax. Assuming your spouse is a U. S. citizen, gifts of any size to your spouse - lifetime or at death - do not "use up" any of the $1 million gift tax shelter, and are not included in the tax calculation. (Lifetime gifts to non-citizen spouses have a much lower limit - $120,000 in 2006. There are also much different rules pertaining to the marital deduction available to these couples, and they should seek legal counsel from an attorney familiar with this situation.) 

BEWARE ! But be careful if the combined marital estate is approaching the amount of the "standard" shelter ($2.0 million for 2006 - 2008). Many married couples avoid valuable tax planning by reasoning as follows: They think, "Fine, our combined estate is well over $2.0 million, but each of us only owns half, so each of our estates is too small for federal estate tax to kick in at all. And even if our estates were much larger, each of our simple Wills leaves everything to the surviving spouse, so there won't be any federal estate tax due anyway, because of the unlimited marital deduction."

That's all true - upon the death of the first spouse. But what happens when the second spouse finally dies? (For simplicity, assume the second death is also in 2006 - 2008.) At that point, he/she will still have a $2.0 million shelter, but only one - his/her own. The shelter of the first spouse to die was not used and has been lost. So, an additional $2.0 million of family wealth that could have passed tax free to the couple's heirs, will instead be subject to federal estate tax. The proper plan to make use of both "standard" $2.0 million (for 2006 - 2008) estate tax shelters is discussed later.

BEWARE ! - if you have an old Will drawn in a community property state. Prior to 1982, the unlimited marital deduction from federal gift and estate tax did not apply to community property. In other words, one could not pass to the surviving spouse, entirely tax free, his/her half interest in marital property, as could be done in a common law state. Obviously, a Will drafted then is not likely to take advantage of current law. Because the unlimited marital deduction is a focal point of estate planning, such Wills should definitely be reviewed and revised.

Unlimited exclusion for gifts made in payment of another's medical or tuition costs. Payments must be made directly to the institution, not just earmarked for this use and given to the beneficiary.

Gifts to charity. The IRS has a list of qualified charities, including all the "household names."

C. A simple living Trust will not save any tax

Keeping property in a Trust and out of your probate estate does NOT mean you pay no income tax on income from that asset. Nor does it mean the asset is out of the taxable estate for federal estate tax purposes. To accomplish tax savings of either kind, a variety of more complicated, irrevocable Trusts are available (see below).

For income tax purposes, whether or not a Trust will be recognized as a separate entity depends on the degree of control retained by the Grantor. Basically, any meaningful, ongoing control over Trust property that one might want to keep, would make it a "Grantor Trust" under the tax code. (E.g., The mere power to revoke makes any revocable Trust a "Grantor Trust.") "Grantor Trusts" are completely ignored by the IRS for income tax purposes. The Grantor would be taxed as if the Trust property were owned in his individual name, and no Trust existed.

For estate tax purposes, the Grantor Trust regulations do not apply, but the "no strings attached" rule still does, and the result is basically the same. A Trust can be drafted to enable the Trustee to handle a wide variety of future situations, but if it is intended to avoid inclusion in your taxable estate, it must be written in stone. Certainly, any Trust that the Grantor can revoke will be included in his/her taxable estate. Likewise, if the Grantor retains the power to change the terms of the Trust in any significant way.

Wouldn't it be nice to have the tax advantages of an irrevocable Trust, while maintaining formal control? Obviously, we assume any Trustee chosen is going to respect your opinion. But can you create a Trust, useful for tax planning, while retaining the power to give the Trustee binding directions? No.

The bottom line is simple: To keep property out of the taxable estate - with a Trust or not - you must give up both control and the right to receive personal benefit. That is what "no strings attached" means.

Especially in this area, do not try to be "cute" with the tax law. If something is not allowed because of a particular rule or law, and you concoct a plan that seems to get around it - think twice. Experience shows that, 99.99% of the time, these "great plans" are totally ineffective. Unfortunately, you (or your heirs) might not find out until it is too late that the IRS does not accept your scheme.

The Internet has allowed a variety of scam operators to reach and separate unfortunate suckers from their money. Be watchful for emails touting "too good to be true" income and estate tax benefits, as well as ironclad protection from creditors, all while you have unfettered access to your property.

These arrangements include the so-called "Pure" Trust, also known as the Liberty, Freedom, Constitutional, Contract, or Common Law Trust. These are ALL complete scams and their promoters are thieves. The pitch usually involves a convoluted, totally bogus legal explanation - and a warning that no lawyer can be trusted to advise you on this. Just forget these enticements. The claimed tax advantages cannot be lawfully obtained, and the IRS has announced a crackdown on these arrangements.

So, revocable Trusts (and others with strings attached or benefits retained by the Grantor) should be considered with the intention of achieving non - tax objectives, such as avoiding probate court, planning for disability and flexibility in property management. Those concerned with tax savings must consider a Trust that is irrevocable, and has none of the other prohibited "strings." (More later.) As a trade-off, irrevocability presents the obvious and significant drawbacks associated with losing control over one's property.

Small income tax savings might be possible in some families through the use of an irrevocable Trust. Irrevocable Trust income will be taxed using special Trust tax brackets, rather than the beneficiaries' brackets, unless the income is actually received by them. But the 1993 tax bill greatly lowered the amount of Trust income subject to these favorable rates, so this should not be a motivating factor for most people.

D. Lifetime gifts vs. transfers at death

Even though the nominal federal gift and estate rates are the same, it takes more money to transfer a given amount, after taxes, upon death than by lifetime gift. The gift tax is calculated like a retail sales tax - just apply the appropriate percentage to the amount of the gift. BUT the federal estate tax is levied on the whole estate "pie." Tax is paid first on everything - including money that is about to be sent to IRS to pay those very taxes. So the effective rate of the Estate Tax is higher. Thus, lifetime gifts are a more "tax efficient" way to transfer wealth.

BEWARE ! But think twice before making a lifetime gift of any kind of property that has appreciated significantly in value since acquisition.

Prior to the 2001 tax law changes, as a general tax rule, other factors aside, it was better to make present gifts of property that is expected to appreciate significantly in the future, so that the increase in value occurs while somebody else - presumably younger - owns the property. In that way, estate taxation is either avoided, or, at least, delayed for another generation or more. In contrast, it is better to give by Will property that has already gone up significantly in price - like company stock you've owned since Day One.

The reason for this difference lies in the arbitrary distinction under the law - at least for now - as to how the donee of the property must compute his/her profit ("capital gain") for income tax purposes - IF the property is ever sold. The key concept involved is tax "basis," and it is appropriate to digress here, so that this important term can be considered. "Basis" can be imprecisely, but adequately, explained as follows:

When property is sold, the seller is taxed on any gain - the difference between the sale price received and his tax basis in the property. Generally, your tax basis in property is the amount originally paid for it, plus the cost of any significant additions, upgrades or improvements you made. (Ordinary operating expenses and upkeep are not included in this calculation. If the property is used to produce income, however, these costs are simply deducted each year.) So, the higher the basis you can claim at the time of a property sale, the lower will be the amount of gain subject to income tax.

To keep things simple, let's consider an asset with a basis - while you own it - that is simply the price you paid. This might be stock in a blue chip company you have owned for many years. But what would be your daughter's tax basis, if she receives this stock by a lifetime gift, or an inheritance, and pays nothing for it? The answer is not "zero" in either case, but there is a big difference between the gift and inheritance situations. Until the 2001 law changes things after 2009, and even thereafter, to a lesser extent, special rules apply, in which the taxpayer can get a rare and valuable break from the tax code when property is acquired through an inheritance.

Property given by lifetime gift takes the same tax basis in the recipient's hands as the donor had - generally, the price the donor paid. This is called a "carry-over" basis. But property received by inheritance does not keep the old basis it had in the donor’s hands; it receives a new, "stepped-up" basis for tax purposes. The new basis, which the donee uses to calculate taxable gain if she sells, takes a "step up" to the fair market value of the property on the date of the estate owner’s death. So, if your daughter sells the stock she inherited from you immediately for its fair market value, there will be little or no taxable gain. A lifetime of appreciation in value can totally escape taxation.

This will no longer be true after 2009. Under the 2001 law, the income tax basis of property owned by a person at death will no longer be permitted an unlimited "step up" to its fair market value on the day he died. Instead, a basis step-up of only $1.3 million will be given, with an additional $3.0 million in step-up allowed on property passing to a surviving spouse.

For the time being, however, the following examples are worth understanding:

Example 1: Dad gives Junior 1000 shares of stock in a corporation. (There are no federal tax consequences to Junior unless and until he sells.) Junior sells it the next day at the market price of $60 per share, for a total to him of $60,000. Dad had paid only $50 per share two years ago. What is Junior’s gain? In reality, Junior has "gained" $60,000 he did not have before. But he takes Dad’s basis of $50,000 (the price Dad paid), so Junior’s taxable gain will be only $10,000. ($60,000 - $50,000.) This, of course, would have been Dad’s true profit had he kept the stock himself and sold it.

Example 2: In 1970, using his separate funds, Dad bought 1000 shares of stock in XYZ Co. for $1 per share. His tax basis is simply the price paid. Assume he dies and leaves the stock to Junior in 1995, when it is selling at $75 per share. This becomes Junior’s basis. It has been stepped up, and he will recognize no taxable gain if he sells at that price.

Example 3: (This is a bit more complicated.) In 1970, Mom and Dad bought 1000 shares of stock in XYZ Co. for $30,000, while living in a common law state. They own it jointly, with right of survivorship. Both became terminally ill, and at that time the fair market value of the stock was $280,000. What is the most tax-efficient way of passing the stock to Junior? (Again, there will be no federal tax consequences to Junior upon receiving the property itself; we are talking only about taxation of the proceeds if it is then sold.)

Assume Dad dies first, and soon thereafter, Mom decides to give the stock to Junior on her deathbed. Junior takes the basis in the stock that Mom had, as in Example 1. How do we determine Mom’s basis? It is not $30,000, the purchase price. Remember, as one of two joint tenants, Mom originally owned only half the stock, and her basis for tax purposes was half the price paid - $15,000.

But since then, as a surviving joint tenant, she acquired Dad’s half interest as a result of his death. In this situation, she gets a step up in basis as to that half from Dad. The new basis is fair market value on the date of Dad's death; the fair market value of half a $280,000 block of stock is $140,000. What about the other half of the block - the one Mom owned from the beginning? No step up on this half. Mom’s basis remains at $15,000 - her half of the original price.

If Junior takes the stock from Mom as a deathbed gift and sells it immediately for $280,000, he also takes Mom’s basis and uses it to calculate his taxable gain. Look at the stock sale one half at a time. For the half that Mom had just acquired from Dad, Junior has a "good" (i.e., high) basis - $140,000. That was the fair market value of this half when it very recently passed to Mom, at the moment of Dad's death. Assume the price has not moved since, so $140,000 is half Junior's selling price. Remember that taxable gain is the difference between the sales price ($140,000) and the taxpayer's basis (also $140,000). Therefore, there is no taxable gain on this half. For the other half of the stock, Junior also receives $140,000, and he again takes Mom’s basis. But this is the half she owned all along. She got no step-up in basis when Dad died. Her basis in this half remains her share (one half) of the $30,000 price Mom and Dad paid years ago, or $15,000. Junior should report a taxable gain of $125,000 ($140,000 - $15,000).

If the stock is bequeathed to Junior in Mom’s Will, however, his basis in the full block of stock is stepped up to fair market value, which we have assumed is $280,000. Therefore, if the stock is then sold by Junior at that price, no gain is recognized, and no income tax need be paid on the $250,000 increase in value.

F.Y.I. There is a potentially important twist to this as it relates to community property: Assume each spouse has a Will that leaves his/her half of all community property to the survivor. When the first spouse dies, the survivor gets the benefit of a step up in basis, not only on the half newly acquired from the decedent, but also on the half he/she already owns. This can result in big tax savings if the property involved has appreciated significantly in value since its purchase. It is a factor favoring community ownership of assets purchased by the married couple, rather than joint ownership, with right of survivorship - in the community property states where there is a choice.

In a common law state, by contrast, whether the surviving spouse gets the decedent’s half by Will, or as a surviving joint tenant, the step up only applies to the newly acquired half of the property - not the half the survivor already owned. Note, however, that this step-up advantage of community property will be eliminated by the 2001 tax law, after 2009.

Obviously, the community property step-up benefit is only available to a couple who have lived - at some point - in a community property state. Yet they need not live there at the time of the first death to receive this benefit. Federal law respects the characterization of property as separate or community made by each state. Most common law states, in turn, respect and retain the community character of property owned by spouses who move there from a community property state.

Your comments, suggestions and constructive criticism are welcome.