Estate and gift tax
The federal "unified estate and gift tax" imposes a tax on assets passed at death, and on lifetime gifts to prevent persons from avoiding the estate tax by disposing or gifting assets during life and before death.
State inheritance tax
Individual states also impose inheritance taxes. There is a credit for state death taxes against the federal estate tax.
The taxable estate is the value of the assets owned at death and lifetime transfers, less debt, last expenses, charitable bequests, other credits (e.g., state death taxes), the amount transferred to the spouse, and taxes payable on lifetime transfers. The estate tax is imposed on the taxable estate.
There is a "unified credit" against the estate tax that prevents most decedents other than wealthy individuals from paying this tax. For 2007 the credit is $780,000 so an individual can transfer $2MM (increasing to $3.5MM in 2009) at death before tax starts to be incurred at a 45% rate. The gift tax applies to lifetime transfers exceeding $1MM. The applicable credit must be used to offset gift taxes on lifetime transfers, regardless of the amount used, and the full credit is allowed against the tentative estate tax at death.
The estate tax goes away entirely in 2010, but is reestablished in 2011 unless Congress passed additional legislation. The gift tax remains in effect regardless.
The credit allowed to the first spouse to die can not be passed on, and the assets passed from the first spouse to the survivor will be included in the estate of and be taxed on the death of the second spouse. There have been proposals to allow this but they have not been implemented. To not loose the credit the allowed amount of assets must be transferred to someone other than the surviving spouse, such as children or a "credit shelter" trust.
Distributions to spouses
An unlimited amount can be passed to a spouse without application of the estate and gift tax, either during life or at death. IRC § 1041 also provides gain (income tax) is not triggered by the transfer of property to a spouse. The spouse's, as other gift recipients', basis in the transferred property is the same as the transferor's basis for determination of gain on later disposition.
Deferral of payment of the estate tax
Where a substantial portion of the decedent's estate is tied up in a business there is a provision to defer the tax for up to 10 years at a reduced interest rate or at least a portion of the deferred tax. The intent is to allow time for payment of the tax so as to not require small family businesses to be sold to pay the tax.
There is also an annual exclusion amount, currently $12,000 per year, which applies for each donor and each separate donee. E.g., both parents can each give each of their three children $12,000 each year, $24,000 to each child and total of $72,000 annual gifts. One spouse can also allow the other spouse to use their annual exclusion, so one spouse can give $24,000 ($12,000 times 2) to one person.
Current and annual gifting programs
There may be steps you can take to facilitate the the tax effective transfer of your assets, such as:
- You can currently transfer assets that you anticipate will appreciate substantially before your death. While such an immediate transfer will use some of all of your unified estate and gift tax credit, it will remove an asset from your estate at the much lower current value, that will be worth substantially more at your death, and if still in your estate substantially increase your tax.
- You can implement an annual gifting program, e.g., a husband and wife together gifting $24,000 ($12,000 each) to each of 2 children, each of their children's 2 spouses and 6 grandchildren can remove $240,000 each year from their estate and over $1MM over 5 years, without using any of the unified credit.
The downside to gifting is that you have to relinquish the assets, and many persons are concerned that they may need of those assets due e.g., extended illness and need for home help to stay in the home rather than moving to assisted living or a nursing home.
Gift tax is cheaper than estate tax
Although the rates are currently the same, the gift and estate taxes are calculated differently. Tax is calculated on the amount gifted and does not include a tax on the money used to pay the tax (e.g., $3MM gift and $1.35MM tax at 45% for a total cost of $4.35MM). The entire taxable amount left at death is taxed, including the amount that will be used to pay the estate tax, so there is less to transfer (e.g., $4.35MM taxable estate with tax of $1,957,500 at 45% with $2,392,500 transferred). Lifetime gifts also have the benefit of reducing the size of what would otherwise be included in the taxable estate by increases in value of gifted property after the gift.
Valuation and partial gifts
It is possible to deal with assets to minimize the value included in your estate or divide the interests to allow gifting and still retain control.
Assets can be subject to a number of valuation discounts, including:
- minority / lack of control – the owner of a minority interest or of non-voting interest is basically "along for the ride" and has no say in the management, disposition or shifting of investment to a different investment
- blockage – if there is a large amount of a particular kind of asset (land in a particular area) it will depress the market price to put it on the market at once and will either take a substantial time to liquidate or have to be marketed over a period of time
Valuation discounts permit more of an asset to be gifted without tax in an annual gifting program or using the lifetime exemption. E.g., a corporation valued at $1MM with 1,000 shares would seem to have a per share value of $1,000, and e.g., 12 shares could be gifted under the annual exclusion amount. If a 25% minority discount is appropriate the annual gift could be 16 shares.
A corporation can have voting and non-voting stock, and the owners of the voting stock are in control. Shareholders can "reorganize", create new non-voting stock, and issue shares of non-voting stock pro-rata to owners of voting stock (e.g., 10 shares of non-voting stock issued for each share of voting stock owned). They would then be able to gift away a large part of the value by gifting the non-voting stock, while keeping the voting stock and control of the corporation. The gifting can be combined with an annual gifting program to divest value in a corporation over time, and allows e.g., parents can move value out of their estate while continuing to control the management of the business. The small non-control stock interests in the corporation are typically entitled to a minority discount.
Another common took is the family limited partnership ("FLP"), while allows you to retain the general partnership interest and control while gifting away a substantial portion of the value. Additionally the FLP can achieve valuation discounts.
The IRS is suspicious of valuation discounts and frequently challenges them. it is very important to form, structure and document them properly to avoid a dispute or be successful if challenged.
Legislative limits on valuation discounts are being considered. 6/7/09