Chapter 7.2 The Federal Estate Tax

• Jurisdiction: Washington

§7.2 THE FEDERAL ESTATE TAX

As indicated above, the federal estate tax is an excise tax imposed on the transfer of wealth at death. The determination of estate tax liability begins with the computation of the decedent's "taxable estate." The taxable estate is defined as the gross estate less certain deductions.

(1) The gross estate

I.R.C. §2031(a) defines the gross estate as including the value of all property to the extent required by I.R.C. §§2031-2044. The gross estate includes not only property actually owned by the decedent at death (the actual gross estate) but also certain assets and interests owned by others with respect to which the decedent has certain powers, incidents of ownership, or other rights (the artificial gross estate). This section begins with a discussion of the actual gross estate, I.R.C. §§2033 and 2034; and then considers inclusion of the artificial gross estate, I.R.C. §§ 2035-2044.

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Conceptually, it is helpful to think of the gross estate as a snapshot of the decedent's assets taken as of the moment of death.

(a) Property held at death, I.R.C. §§2033-2034

Logically enough, the actual gross estate includes property held by the decedent at death, including certain property the decedent may not be able to transfer at death because of state law constraints.

Property in which the decedent had an interest, I.R.C. §2033

Under I.R.C. §2033, a decedent's estate includes "all property to the extent of the interest therein of the decedent at the time of his death." Accordingly, the gross estate of a married decedent includes all of the decedent's separate property and one-half of the community property. Inclusion under I.R.C. §2033 is a two-part test. First, the decedent must own an interest in property immediately prior to death. It is not necessary that the decedent own a specific item of property, just that the decedent own an interest in property. On the other hand, the proceeds from a wrongful death action would not be included in the gross estate because the right to commence such an action arises at or immediately after the decedent's death, not immediately before death. Conn. Bank & Trust Co. v. United States, 465 F.2d 760 (2d Cir. 1972); Rev. Rul. 75-127, 1975-1 C.B. 297.

Second, the decedent must have held the right to transfer that interest at death. If an asset simply disappears at death, it is generally not included in the gross estate. For example, suppose G creates a trust giving X income for life and a remainder to D if D is living at X's death. If D does not survive X, the remainder passes to Y or Y's estate, and Y has a general power of appointment to designate where the trust is distributed at Y's death. If D dies while X is still alive, D's gross estate will not include the value of the contingent remainder, because the interest would expire upon D's death. Likewise, the value of X's life estate will not be included in X's gross estate because it expires at X's death. However, if Y dies while both D and X are still living, Y's gross estate will include the value of Y's contingent remainder. Why? Because Y's contingent remainder does not die with Y; Y can designate under Y's power of appointment who will succeed to Y's interest in the contingent remainder.

Likewise, the gross estate includes the value of a promissory note payable to the order of the decedent, even if the decedent's will provides for forgiveness of the balance of the note. Treas. Reg. § 20.2033-1(b). If the promissory note itself contains a clause that forgives repayment

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in the event of decedent's death, the value of the note may not be included in the decedent's gross estate. See Estate of Moss v. Comm'r, 74 T.C. 1239 (1980).

Whether a decedent "owned" property for federal estate tax purposes is a question of state law. If the state's highest court has interpreted state law, the Internal Revenue Service (IRS) is bound by that decision in examining an estate or gift tax return. Comm'r v. Estate of Bosch, 387 U.S. 456, 87 S.Ct. 1776, 18 L.Ed.2d 886 (1967) (non-acquiescence). The IRS is not bound by any lower court interpretation of state law unless it was a party to the underlying proceeding. Nonetheless, the IRS has ruled that it will follow a lower court's interpretation if that decision made a binding determination of the decedent's interest in the property at issue. Rev. Rul. 73-142, 1973-1 C.B. 405.

Because I.R.C. §2033 requires inclusion of any interest in property that the decedent held at death, the gross estate is a significantly broader concept than the probate estate. Although most assets subject to probate will be included in the gross estate, the gross estate also includes the decedent's interest in nonprobate assets such as life insurance death benefits and retirement plan benefits (although many nonprobate assets are subject to special rules discussed below in §7.2(1)(c)).

Dower or curtesy interests, I.R.C. §2034

I.R.C. §2034 requires inclusion of a decedent's dower or curtesy interests, state law rights to a decedent's property conferred to the decedent's surviving spouse. Although the decedent has no power to transfer property subject to these rights (thus leaving such property outside the scope of I.R.C. §2033), such property is still included in the gross estate.

As mentioned above, I.R.C. §2033 requires inclusion of the decedent's one-half share of community property. I.R.C. §2034 does not change this result, nor does it affect the result in any way because community property rights vest at creation, not at death. I.R.C. §2034 is aimed at dower-type rights that vest at death and are dependent upon the continuation of the marriage until death.

(b) Inclusion provisions, I.R.C. §§2035-2038 & 2043

Although the "snapshot" metaphor is helpful in understanding the basic rules of inclusion and valuation, it is not wholly accurate by itself. In some cases, a decedent may continue to have so much control

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or influence over property previously transferred by the decedent that the property should be included in the decedent's gross estate even though the property was not legally owned by the decedent at the date of death. Congress has identified four transactions that raise this "inclusion" problem: (1) transfers with a retained life estate, I.R.C. §2036; (2) transfers taking effect at death, I.R.C. §2037; (3) revocable transfers, I.R.C. §2038; and (4) certain transfers within three years of the decedent's death, I.R.C. §2035.

Transfers with a retained life estate, I.R.C. §2036

Suppose D transfers property to a new irrevocable trust, retaining the right to income from the trust assets for life. At D's death, the trust will terminate and the remainder will pass to the beneficiaries identified in the trust instrument. By retaining one of the most important rights associated with property, the right to income, no wealth transfer really occurs until D's death. Accordingly, although the transfer to the trust involved a taxable gift of the remainder interest, I.R.C. §2036 requires inclusion of the trust property in D's gross estate. The same result occurs if D retains rights to possess or enjoy the trust property. This situation can arise, for instance, when a grantor transfers his or her personal residence to a trust and continues to occupy the home until death. Inclusion under I.R.C. §2036 can even result when the grantor does not retain rights to income or possession; if the grantor can, alone or with others, still designate who will enjoy the income or possession of the trust property, there is a risk of inclusion. This situation most frequently occurs when the grantor holds a power to allocate trust income between two or more beneficiaries.

For I.R.C. §2036 inclusion to occur, a grantor must have retained the rights to income and/or possession (or the rights to designate who shall receive income and/or possession) for life, for a period not ascertainable without reference to the grantor's death, or for a period that does not in fact end before the grantor's death. Thus, one should always approach I.R.C. §2036 as a two-pronged test for inclusion: (1) does the grantor hold a prescribed interest (right to income, right to possession, or right to control income and/or possession) (2) for a prescribed period (for life, for a period unascertainable without reference to the grantor's death, or for period that does not end prior to the grantor's death)?

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Example: D transfers property to an irrevocable trust, retaining the right to receive income from the trust property annually for D's life. At D's death, the then-remaining trust property shall pass to B or B's estate. The trust instrument further provides that all income accrued in the month prior to D's death shall be paid to B or B's estate. Because D has retained the right to income for a period not ascertainable without reference to D's death, I.R.C. §2036 requires inclusion of all trust property in D's gross estate.

Example: D transfers property to an irrevocable trust, retaining the right to receive income from the trust property annually for a term of 10 years. At D's death, the then-remaining trust property shall pass to B or B's estate. D dies six years into the ten-year term. Because D retained the right to income for a period that did not end prior to D's death, I.R.C. §2036 requires inclusion of all trust property in D's gross estate.

A decedent will be considered to have held a prescribed interest in transferred property if use, possession, enjoyment, or right to income from the property is to be applied to discharge a legal obligation of the decedent. Treas. Reg. § 20.2036-1(b)(2). In addition, if the transferor retains a prescribed interest that does not affect another's prior income interest in the same property, the amount included in the gross estate under I.R.C. §2036 is the...