Federal Tax Basics

THE  “DEATH TAX”. The federal estate tax is a tax on the transfer of wealth from a deceased person to others, usually his family. At its simplest, you add up the estate, subtract the deductions, subtract the exemption amount, and tax the rest. The federal gift tax is imposed on the act of transferring any kind of property and receiving less than an equivalent value in money or money’s worth sufficient to restore the equivalent value to your hands. Whether you transfer assets at your death or transfer assets gratuitously during life, the federal law applies a tax to the act of transferring property. Current law allows the tax-free combined lifetime and at-death transfer of $5,430,000.00. This amount will rise as time passes because the exemption is to be adjusted for inflation.

To know whether there are potential federal tax problems the first step is to determine what assets are taxable as part of the “estate”. In a nutshell, it’s everything you own. It includes everything from the obvious, like stocks, bonds, cash, to the not so obvious, like tax-free municipal bonds, annuities and life insurance proceeds, assets in a revocable grantor trust, and sometimes even property that you gave away decades earlier. It includes the full value of IRA and 401(k) accounts, deferred compensation, loans receivable, your home, furnishings, jewelry, everything that has value. It does not matter that life insurance or bank accounts might pass to the heirs by beneficiary designation or through a revocable living trust. The critical issue is the deceased person’s legal right to control or dispose of the property while he or she was alive.

Rules that govern the taxation of gratuitous transfers (during life and at death) consist of statutes, regulations, Revenue Rulings, Revenue Procedures, case law from all the various courts, the Internal Revenue Manuals and other authoritative resources. For those who might wish to sample the complexity, the statutes in only one portion of the Internal Revenue Code (Title 26 of the U.S. Code) can be perused through this link. Some of the regulations that are applicable to federal estate tax can be accessed through this link. Be aware that many of the statutes and regulations published by the government on these two sites have not yet been updated to reflect the law congress enacted at the end of 2010.

“Bunching” and the marital deduction dilemma: Federal estate and gift tax rules allow a deduction for transfers to a spouse. Thus, if a decedent’s estate net of all debts and costs of administration passed outright to a surviving spouse there would zero federal estate tax regardless of the value transferred. However, the rules require that all property so transferred to the surviving spouse is to be included in the gross estate of that spouse at their death. Sometimes it is not wise to “bunch” all of the assets from both spouses into a single taxable value. Estates that would otherwise not be subject to federal estate tax can be made taxable when the values of both estates are combined. Under the law, various planning techniques and devices were forged to establish time-honored ways to minimize the “bunching effects.” One of the most common approaches is to combine the use of a Marital Deduction Trust (to be administered and distributed to the surviving spouse) with a Bypass Trust (for the purpose of making tax-reducing use of the ability to pass assets to any person free from federal tax). Marital trusts assure a surviving spouse’s access to the benefits of assets for the balance of life; but by using the trust-arrangement, the estate’s executor is allowed to take changed circumstances in account. Because a will with a marital trust is often executed long before death of the testator, circumstances will tend to change greatly. What if changed circumstances should empower the executor to NOT elect to take a marital deduction for the entire value of property put into the trust? What if those changed circumstances should empower the executor to instead elect to claim NO MARITAL DEDUCTION at all?

Marital trust provisions can empower executors to make decisions about making the required election to claim all, part or none of the deduction. In that way, all the changes that occur over the years will not necessitate the constant re-drafting and changing of a will. Planning to provide for marital trust provisions that fluctuate according to federal tax effects can provide methods for minimizing tax according to changed circumstances.

Federal Gift Tax basics:
A gift occurs when property is transferred and you do not receive equivalent value in money or money’s worth. Just because a person enters a “bad bargain” and receives less value in the exchange there is not a gift when the transaction occurred at arm’s length. But there is likely a gift when, for example, parents loan money to children and either forgive the debt or fail to collect the debt. It is sometimes difficult for citizens not skilled in the federal gift tax law to recognize gift-transfers.

At present the law provides that you may make gifts up to $13,000 per donee every year. This amount tends to increase at time passes because it is indexed to inflation. There is no obligation to even file a gift tax return reporting gifts equal to or less than this “annual exclusion” amount. Every year, you may make gifts up to that “annual exclusion” amount. To qualify for the annual exclusion you must transfer a “present interest.” Unless a present interest is transferred you may not apply the annual exclusion to avoid the filing requirements. A future interest is, for example, a transfer to a trust where the beneficiary is not immediately entitled to any distribution. It is this rule that must be so closely studied and applied when trusts are established for children. Failure to apply the detailed and cumbersome rules governing “present interest” determination can end in making a gift as defined in the Internal Revenue Code.

Also, a gift is made only when the transferor has completely relinquished all dominion and control over the asset so as to put it beyond the donor’s control. It is one of the reasons why “revocable trusts” are employed when very large values are transferred to trusts. When it is revocable, the transfer can be taken back – it is not a “completed transfer” and the gift tax applies only to completed transfers.

The Federal Gift Tax is a very complicated legislative scheme. It is critically important to understand all the rules, and to apply those rules to maximize your objectives and minimize tax consequences. Much (but not all) of the federal law applicable to federal estate, gift and generation skipping tax may be found at this link. The government changes the location of its pages with some frequency, and if this link ceases to open the index to the code sections the statutes are always available through other means on the internet. And many of the Federal Regulations governing the gift tax provisions may be perused through this link. The resources accessible through these links are NOT all of the federal law that is of concern in regard to making gratuitous transfers; but, a casual perusing of these resources will inform readers that the area is complicated and difficult to navigate.

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