This is the first installment of a two-part article on the federal estate tax. Part 1 discusses the unified federal estate and gift tax rules, the exemption amount, the definition of a gross estate, gifts made within three years of death, estate valuation, and portability. The second part, to appear in the November JofA, covers estate tax plan ning techniques, including maximizing the marital deduction and the use of various types of trusts.
OVERRIDING GOAL:TAX MINIMIZATION
A major area of personal financial planning is planning for the transfer of property during an individual's lifetime and at death. Although most individuals do not have enough money to be concerned about federal gift and estate taxes, minimizing gift taxes and estate taxes is a primary financial goal for many millionaires and billionaires.
The federal estate and gift tax is referred to as a unified tax because both taxes use the same tax rate schedule and the same credit against the tax, called the unified credit. The unified credit amount in 2017 is $2,141,800, which is the tax on $5,490,000 of taxable value (the calculations in this article are based on 2017 figures). This $5,490,000 is called the basic exclusion amount.
An individual will be liable for the gift tax only if during the individual's lifetime he or she transfers property by gift in excess of the basic exclusion amount. Because the basic exclusion amount applies to both the gift and estate tax, an individual's estate will be liable for the estate tax only when the taxable value of the estate exceeds the individual's exclusion amount, less the amount of taxable gifts the individual made during his or her lifetime.
The federal estate tax is owed by only about 1 out of 700 estates. It has gone through many changes since 2001 when estates with a taxable value of more than $675,000 were liable for the estate tax. This amount was increased gradually from $1 million in 2002-2003 to $5 million in 2010-2011. After 2011, the $5 million basic exclusion amount is adjusted for inflation; for 2017, it is $5.49 million.
This article discusses the mechanics of the estate tax as well as a number of planning techniques to minimize the federal estate tax so that the estate can transfer the maximum value to its beneficiaries. Although this discussion focuses on the federal estate tax and does not review state estate taxes, the relevant state rules must also be addressed as part of an individual's financial plan.
Under Sec. 2001(a), the estate tax is imposed on the transfer of the taxable estate of every decedent who is either a citizen or a resident of the United States. The estate tax is calculated by adding together the decedent's taxable estate (the gross estate less allowable deductions) and the decedent's adjusted taxable gifts to determine the estate tax base (see the table "Formulas for Calculating Estate Tax Base and Net Estate Tax Liability").
Adjusted taxable gifts are taxable gifts made by the decedent after Dec. 31,1976, other than gifts that are includible in the gross estate of the decedent. Next, the estate tax rates are applied to the estate tax base amount to determine the tentative estate tax. Gift taxes paid by the decedent after 1976 are then deducted from the tentative estate tax to arrive at the gross estate tax. Finally, the decedent's remaining unified credit and any other credits are deducted from the gross estate tax to determine the decedent's net estate tax liability.
Estates use Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, to calculate the estate tax liability of a decedent (this article does not address generation-skipping transfer (GST) taxes). Estates with a gross estate, plus adjusted taxable gifts, of more than the exclusion amount for the decedent's year of death, and estates of any size whose executor elects to make a portability election, need to file an estate tax return, which is due within nine months after the date of the decedent's death.
The gross estate includes all property, real or personal, tangible or intangible, wherever situated (Sec. 2031(a)). An estate lists property included in the gross estate on Form 706, Part 5, "Recapitulation," lines 1-10.
The gross estate includes the proceeds of life insurance in two situations (Sec. 2042):
* When the proceeds of life insurance are received by the estate as the beneficiary on a life insurance policy where the decedent is the insured; or