The estate tax is designed to tax the value of property owned or controlled by an indi- vidual at death, the decedent. Because federal gift and estate taxes are integrated, taxable gifts affect the tax base for the estate tax. Exhibit 25-6 presents the estate tax formula.
LO 25-3
EXHIBIT 25-6 The Federal Estate Tax Formula Gross estate
Minus Expenses, debts, and losses Equals Adjusted gross estate
Minus Marital and charitable deductions Equals Taxable estate
Plus Adjusted taxable gifts
Equals Cumulative taxable transfers (the tax base) Times Current tax rates
Equals Tax on cumulative transfers
Minus Gift taxes payable on adjusted taxable gifts at current rate Equals Tentative tax
Minus Full applicable credit calculated using current tax rate Equals Gross estate tax
The Gross Estate
Property possessed by or owned (titled) by a decedent at the time of death is generally referred to as the probate estate, because the transfer of this property is carried out by a probate court. The person appointed by the court to carry out the will is called the executor.
Probate is the process of gathering property possessed by or titled in the name of a dece- dent at the time of death, paying the debts of the decedent, and transferring the ownership of any remaining property to the decedent’s heirs. Property in the probate estate can include cash, stocks, jewelry, clothing, and realty owned by or titled in the name of the deceased at the time of death.
continued from page 25-1 . . .
Early this year Bob was injured in an auto accident. Unable to recover from his injuries, he died after two days in the hospital. Bob is survived by his son, Nate, who is also the executor of Bob’s estate. Nate is now collecting his father’s assets, and he would like help in preparing Bob’s federal estate tax return. ■
What if: Nate took an inventory of his father’s property in preparation for distributing assets according to Bob’s will. Nate must report this preliminary inventory of personal and investment property to the probate court; it includes the following:
Fair Market Value
Auto $ 33,000
Clothes, furniture, and personal effects 48,000 Smith painting (original cost/initial estimated value) 25,000
Checking and savings accounts 75,250
FFP stock 19,500,000
Residence 400,000
Other investments 8,200
Total $20,089,450
(continued on page 25-18)
Example 25-11
The gross estate is broader than the probate estate. The gross estate consists of (1) the fair market value of property possessed or owned by a decedent at death plus (2) the value of certain automatic property transfers that take effect at death.13 Property transfers that take effect only at death are not in the probate estate because the transfer takes place just as death occurs. Hence, the probate court does not need to affect a transfer.
Specific Inclusions Besides property in the probate estate, the gross estate also includes property transferred automatically at the decedent’s death. These automatic transfers can occur without the help of a probate court because the ownership transfers by law at the time of death.
Certain automatic property transfers are specifically included in the gross estate because, while the decedent didn’t own the property at death, Congress deemed that the decedent controlled the ultimate disposition of the property. That is, the decedent effec- tively determined who would receive the property at the time of death. A common ex- ample is property held in joint tenancy with right of survivorship, which legally transfers to the surviving tenant upon the joint tenant’s death. Joint bank accounts are commonly owned in joint ownership with right of survivorship. In contrast, tenants in common hold divided rights to property and have the ability to transfer these rights during their life or upon death. Property held by tenants in common, such as real estate, does not automatically transfer at death and thus must be transferred via probate. Although the decedent’s interest in jointly owned property (with the right of survivorship) ceases at death, the value of the interest the decedent held in this property is still included in the gross estate.14
What amount of this property is included in Bob’s gross estate?
Answer: Bob’s gross estate includes the value of all the above property, or $20,089,450, because he owned these assets at his death (i.e., these assets are included in Bob’s probate estate). In this exam- ple, Bob’s gross estate and his probate estate are identical, but this would not be the case if Bob owned property that transferred automatically on his death.
What if: Suppose Bob was also entitled to a pension distribution of $15,000 but had not yet received the check at the time of his death. Would this value also be included in Bob’s probate estate and there- fore gross estate?
Answer: Yes. Although Bob had not received the check, he was legally entitled to the property at the time of his death, and therefore it will be included in both his probate estate and gross estate.
Nate and his father jointly own two parcels of real estate not included in the inventory above. One parcel is a vacation home in Colorado. Nate owns this property jointly with Bob and the title is held in joint ownership with the right of survivorship. Will this property be included in Bob’s probate estate and/or gross estate?
Answer: The property will not be included in Bob’s probate estate, but it will be included in Bob’s gross estate. When Bob died, Nate automatically became the sole owner of the property without going through probate. However, the property will be included in Bob’s gross estate because it is an auto- matic transfer that is specifically included in the gross estate by law.
Example 25-12
13§2033. The principle of increasing the gross estate for transfers taking effect at death began with gifts in contemplation of death. So-called deathbed gifts were a device used to avoid the estate tax in the years before enactment of the gift tax.
14§2040. There are a number of other transfers that are specifically included in the gross estate. For example,
§2036 to §2039 and §2041 address transfers with retained life estates, transfers taking place at death, revo- cable transfers, annuities, and powers of appointment. A discussion of these provisions is beyond the scope of this text.
Jointly owned property. The proportion of the value of jointly owned property included in the gross estate depends upon the type of ownership. When a decedent’s interest is a tenancy in common (there is no right of survivorship), a proportion of the value of the property is included in the gross estate that matches the decedent’s ownership interest.
For example, consider a decedent who owned a one-third interest in property as a tenant in common. If the entire property is worth $120,000 at the decedent’s death, then $40,000 is included in his gross estate.
The amount includable for property held as joint tenancy with the right of survivor- ship depends upon the marital status of the owners. When property is jointly owned by a husband and wife with the right of survivorship, half the value of the property is auto- matically included in the estate of the first spouse to die.15 For unmarried co-owners, the value included in the decedent’s gross estate is determined by the decedent’s contribution to the total cost of the property. For example, consider a decedent who provided two- thirds of the total cost of property held as joint tenants with the right of survivorship. If the entire property is worth $240,000 at the decedent’s death, then two-thirds ($160,000) is included in his gross estate.
The second parcel is real estate in west Texas that Nate and Bob hold as equal tenants in common.
Will it be necessary to use probate to transfer ownership of Bob’s share to the beneficiary named in Bob’s will?
Answer: Yes, ownership must be transferred through probate. The value of Bob’s one-half interest in the west Texas real estate is also included in his gross estate.
Another example of an automatic transfer is insurance on the life of the decedent.
Proceeds of life insurance paid due to the death of the decedent are specifically included in the gross estate if either of two conditions is met. The proceeds are included in the gross estate if (1) the decedent owned the policy or had “incidents” of ownership such as the right to designate the beneficiary or (2) the decedent’s estate or executor is the benefi- ciary of the insurance policy (that is, the executor must use the insurance proceeds to discharge the obligations of the estate).
Example 25-13
Bob owned and paid annual premiums on an insurance policy that, on his death, was to pay the ben- eficiary of his choice $500,000. Bob named Nate the beneficiary, and the insurance company paid Nate $500,000 after receiving notification of Bob’s death. Will Bob’s gross estate include the value of the insurance proceeds paid to Nate?
Answer: Yes. The $500,000 of insurance proceeds is specifically included in Bob’s estate despite the fact that it was paid directly to Nate and did not go through probate.
What if: Suppose Bob transferred ownership of the policy to Nate four years prior to his death. Nate had the power to designate the beneficiary of the policy, and he also paid the annual premiums. Will Bob’s gross estate include the value of the insurance proceeds paid to Nate?
Answer: No. Bob had no incidents of ownership at his death (Nate controlled who would be paid the proceeds upon Bob’s death), and the proceeds were not paid to his estate.
15In some states joint tenancy with a right of survivorship between spouses is referred to as a tenancy by the entirety.
Bob and Nate originally purchased the Colorado vacation home seven years ago for $20,000 and held it as joint tenants with the right of survivorship. This property is not included in the list of property in Bob’s probate estate because the title passes automatically to Nate upon Bob’s death. Bob pro- vided $15,000 of the purchase price, and Nate provided the remaining $5,000. The property was worth $400,000 at Bob’s death. How much is included in his gross estate?
Answer: Bob’s gross estate includes $300,000. For property held in joint tenancy with the right of survivorship, the amount included in the gross estate is equal to the proportion of the purchase price provided by the decedent. Bob provided 75 percent ($15,000 ÷ $20,000 = 75%). Hence, his gross estate will include $300,000 (75% × $400,000) of the value of the vacation home.
What if: Suppose Bob was married and owned the home with his wife as joint tenants with the right of survivorship. What amount would be included in Bob’s gross estate?
Answer: The amount included in the estate is half the value of any property held with the surviving spouse as joint tenants with the right of survivorship, $200,000 in this case.
The west Texas land Bob and Nate owned is valued at $500,200. They owned it as tenants in com- mon, with Bob holding a one-quarter interest and Nate holding the rest. What amount is included in Bob’s gross estate?
Answer: The amount included in the estate is $125,050 ($500,200 × 25%), because Bob owned a one-quarter interest in the property.
Example 25-14
Exhibit 25-7 summarizes the rules for determining the value of jointly owned prop- erty included in a decedent’s gross estate.
EXHIBIT 25-7 Amount of Jointly Owned Property Included in Gross Estate Marital Status
Ownership Form of Co-Owners Amount in Gross Estate Community property (discussed above) Married Half the fair market value
Joint tenancy with right of survivorship Married Half the fair market value Joint tenancy with right of survivorship Unmarried Percentage of fair market value
determined by decedent’s contribution to total cost of the property
Tenancy in common Married or Percentage of fair market value determined unmarried by decedent’s interest in the property
Transfers within three years of death. Certain transfers, such as transfers of life in- surance policies, made within three years of the decedent’s death are also included in the decedent’s gross estate, valued as of the time of death. Without this provision, a simple but effective estate tax planning technique would be to transfer ownership in a life insurance policy just prior to the decedent’s death. This strategy, called a deathbed gift, would reduce the decedent’s transfer taxes on the life insurance by the difference between its proceeds from the policy (the value at death) and its value on the date transferred. Only certain transfers are specifically included under this provision, and they are often difficult to identify.
Gift taxes paid on transfers within three years of death. Gift taxes paid on any taxable gifts during the three-year period preceding the donor’s death are also included in the decedent’s gross estate. This inclusion provision prevents donors from escaping estate tax on the amount of gift taxes paid within three years of death. In other words, the amount
of gift taxes paid is included in the estate because it would have been included in the estate had the decedent kept the property until death.
Valuation Property is included in the gross estate at the fair market value on the date of the decedent’s death. Virtually all the factors (and controversies) regarding valuation that we’ve already discussed for the gift tax also apply to the valuation of property for estate tax purposes.
Example 25-15
What if: Suppose Bob owned a life insurance policy and transferred all incidents of ownership in the policy to his son one year before dying from a fatal disease. Also suppose that Bob paid $40,000 of gift taxes on the transfer and the policy paid his son $3 million on Bob’s death. What amount would be included in Bob’s gross estate?
Answer: $3,040,000. Bob’s estate would include proceeds of the policy ($3 million) because Bob transferred the incidents of ownership within three years of his death. The value of the transfer would also include the gift taxes paid ($40,000) when Bob transferred the policy.
Example 25-16
At his death Bob owned an original landscape painting made in the late 1800s by one of his ances- tors, Tully Smith. Bob purchased the Smith painting for $25,000 in 1980, and last year an expert esti- mated it was worth $210,000. Nate now has the painting appraised by another expert, who estimates its value at $250,000 based upon a painting by the same artist that sold at auction last month. What value should be placed on the painting for inclusion in the gross estate?
Answer: Nate should value the painting at $250,000, according to its specific characteristics and at- tributes (such as age, condition, history, authenticity, and so forth). Of course, the IRS might disagree with this value and seek to value the painting at a higher amount.
THE KEY FACTS Valuation of Assets
• Property is included in the estate at its fair market value at the date of the de- cedent’s death.
• The executor can elect to value the estate on an al- ternate valuation date, six months after death, if it re- duces the gross estate and estate tax.
The executor of an estate, however, can elect—irrevocably—to have all the property in the gross estate valued on an alternative valuation date. The alternate date for valuing the estate is six months after the date of death or on the date of sale or distribution of the property (if this occurs before the end of the six-month period). This election is available only if it reduces the value of the gross estate and the combined estate and generation- skipping taxes.16
Example 25-17
What if: Bob’s shares of FFP are included in his estate at a value of $19.5 million. Suppose the value of the shares plummet to $5 million several months after Bob’s death. Further suppose that the drop in value causes the value of Bob’s estate to drop from $28 million to $13.5 million. Could Nate, as executor of Bob’s estate, opt to value these shares at the lower value for estate tax purposes?
Answer: Yes. Nate could elect to value the shares on the alternate valuation date, six months after Bob’s death. However, to qualify for this election, he must value all property in the estate on the alter- nate date. Because the election will reduce the value of the entire gross estate, Nate could elect to use the alternate valuation date.
16§2032A. An executor can also elect to value certain realty used in farming or in connection with a closely held business at a special use valuation. Special use valuation allows realty to be valued at a current use that does not result in the best or highest fair market value. This election is available when the business is con- ducted by the decedent’s family, constitutes a substantial portion of the gross estate, and the property passes to a qualifying heir of the decedent.
At the time of his death, Bob owned a reversion in a trust he established for his favorite cousin, Becky.
Under the terms of the trust, Becky is entitled to income for her life (a life estate), and Bob (or his heir) is entitled to the reversion. At the time of Bob’s death, the trust assets were valued at $100,000, Becky was 35, and the §7520 interest rate was 6 percent. Should this reversion be included in Bob’s gross estate and, if so, what value is placed on the future interest?
Answer: Bob’s reversion interest is included in his estate because this is a property right he owned at his death. Under Table S in the regulations (Exhibit 25-4), based upon Becky’s age and the current in- terest rate at the time of Bob’s death, the percentage of the property that represents the value of Bob’s reversion is .11217. Thus, his reversion is valued at $11,217 ($100,000 × .11217).
What if: Suppose the trust was established for George, age 6. Would this influence the value of Bob’s reversion interest?
Answer: Yes. Under Table S in the regulations and based upon George’s age and the current interest rate, the portion of the property that represents the value of Bob’s reversion is .02749. Thus, Bob’s reversion is valued at $2,749 ($100,000 × .02749).
Example 25-18
Gross Estate Summary So far we’ve seen that the decedent’s gross estate consists of the assets subject to probate as well as certain assets transferred outside probate. These latter assets include property owned by the decedent in joint tenancy with the right of survivorship as well as life insurance. The gross estate also includes certain property transferred by the decedent within three years of death and certain future interests owned by the decedent.
Given previous examples, what is the value of Bob’s gross estate?
Answer: The value of Bob’s gross estate is $21,250,717, calculated as follows:
Property Value Explanation
Auto $ 33,000 Example 25-11
Personal effects 48,000 Example 25-11
Smith painting 250,000 Example 25-16
Checking and savings accounts 75,250 Example 25-11
FFP shares 19,500,000 Example 25-11
Residence 400,000 Example 25-11
Other investments 8,200 Example 25-11 Life insurance proceeds 500,000 Example 25-13
Colorado vacation home 300,000 Examples 25-12 and 25-14 West Texas land 125,050 Examples 25-12 and 25-14 Reversion interest in Dina Trust 11,217 Example 25-18
Gross estate $21,250,717
Example 25-19
The Taxable Estate
Referring to the federal estate tax formula in Exhibit 25-6, we calculate the taxable estate in two steps. The first consists of subtracting from the gross estate the deductions allowed for administrative expenses, debts of the decedent, and losses incurred during the administration of the estate. These deductions are allowed because Congress in- tends to tax the amount transferred to beneficiaries. This step results in the adjusted gross estate. In the second step, the adjusted gross estate is reduced for transfers to a