Estate and Gift Taxes

Once the value of the gross estate has been computed, the estate is entitled to take deductions. Expenses associated with administering the estate, such as funeral expenses, executors' commissions, and attorneys' fees, as well as debts the decedent owed at death, are deductible because they necessarily reduce the value of the property that the decedent actually is capable of transferring (26 U.S.C.A. § 2053(a), (b)). The two most important deductions for tax purposes are the marital deduction and the charitable deduction.

The Marital Deduction The marital deduction applies to certain interests in property passing from the first spouse to die, to the surviving spouse. It permits an estate to deduct the value of certain property included in the estate from the value of the gross estate, thus eliminating the estate tax with respect to that property. The rationale behind the marital deduction is simple: that a husband and a wife should be considered a single unit for purposes of wealth transfer. Accordingly, as a general rule, the marital deduction will be allowed with respect to certain property passing to a surviving spouse, provided that it will be included and taxed in the estate of that spouse on his or her death.

To qualify for the marital deduction, property must satisfy three basic requirements. First, the surviving spouse must be a U.S. citizen. Second, the interest in the property must pass directly from the first spouse to die, to the surviving spouse. Third, the interest generally must not be terminable (26 U.S.C.A. § 2056). The concept of a terminable interest is complex and technical, but for the most part, an interest is terminable for tax purposes if another interest in the same property passes to someone other than the surviving spouse by reason of the decedent's death, allowing that other person to enjoy the property after the surviving spouse's interest terminates. For example, if A leaves to her husband, B, a life estate in her property, with a remainder to their children, her bequest to B does not qualify for the marital deduction. B's interest terminates automatically on his death, and the children, by reason of the termination, will then enjoy the property.

If no one else can enjoy the property following the termination of the surviving spouse's interest, the property interest is not considered terminable for tax purposes, and a deduction will be allowed. For example, if A leaves to her husband, B, her interest in a patent, and dies while the patent has ten years of life left, the patent interest qualifies for the marital deduction, because no one else will enjoy it after it expires.

Whether an interest is terminable must be determined at the time of death. Therefore, even if an event following the first spouse's death makes the termination of the surviving spouse's interest impossible, the marital deduction will not be allowed if it technically was terminable at the time of death.

Congress in 1981 created an important exception to the general rule that a terminable interest does not qualify for the marital deduction. This exception, called the qualified terminable interest property (QTIP) exception, is a sophisticated statutory rule allowing the estate to deduct the value of a terminable interest that passes to the surviving spouse as long as the transfer meets five requirements:

1. the surviving spouse receives all or a specific portion of the income for life from the interest
2. the income from the QTIP … is paid at least annually
3. the surviving spouse has the power to appoint the interest to himself or his estate
4. the power must be exercisable in all events
5. no other person has the power to appoint the interest to anyone other than the surviving spouse (26 U.S.C.A. § 2056(b)(7)) In return for the marital deduction, the estate must agree that the QTIP will be included in the estate of the surviving spouse at death, to the extent that the surviving spouse has not disposed of the property during his or her life (§ 2044).

The Charitable Deduction The charitable deduction permits an estate to deduct the entire value of bequests to any of a number of public purposes, including the following:

• any corporation or association organized for religious, charitable, scientific, literary, or educational purposes
• the United States
• a state or its political subdivisions, and the District of Columbia
• a foreign government, if the bequest is to be used for charitable purposes
• selected amateur sports organizations (26 U.S.C.A. § 2055(a)).

The charitable deduction is intended to provide wealthy individuals a tax incentive to benefit the public interest. Only bequests passing directly from the decedent's estate to the charitable entity qualify for the deduction. Therefore, if A leaves $100,000 to her son C, who gives $50,000 to the Red Cross immediately after A's death, A's estate cannot receive a charitable deduction for the sum given to the charity (§ 2518(b)(4)).