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Estate and Gift Taxes

Testamentary Transfers

The gross estate is the measure of the interests an individual is considered capable of transferring at the time of death, and provides the starting point for computing the estate tax (26 U.S.C.A. § 2031). The gross estate is an artificial concept, in part because it may include interests that the individual did not actually own at death (§§ 2035–2038). From the gross estate are deducted expenses of administering the estate, the decedent's legal obligations at death, the value of property passing to a surviving spouse, and the value of bequests to charity (§§ 2053–2056). The remainder is known as the taxable estate and is the value on which the estate tax is computed.

Conventional interests in property, such as ownership of real estate, stocks and bonds, cash, automobiles, art, and PERSONAL PROPERTY, must be included in the gross estate and valued at their fair market value on the date of death. In addition, interests in life insurance, annuities, and certain death benefits are included to the extent that the decedent was able to confer an interest in them on another person. Finally, three somewhat artificial ownership attributes, including the power to change beneficial enjoyment and the power to revoke or change the type and time of enjoyment, are included in the gross estate to the full extent of the property to which the power applies. The value of property included in the gross estate is equal to its fair market value on the date of death.

Designation of Beneficiaries Life insurance, annuities, and certain death benefits are substitutes for dispositions at death, and are included in the gross estate to the extent that the decedent owned or could exercise "incidents of ownership" over them until the time of death. Thus, the value of a life insurance policy payable to the decedent's estate on death is included in the decedent's gross estate (26 U.S.C.A. § 2042(a)(1)). In addition, life insurance is includable in the gross estate even though neither the decedent nor the decedent's estate actually owned it, if the decedent possessed any incidents of ownership over the policy. Incidents of ownership encompass the rights to change the distribution of the economic benefit flowing from the insurance policy. For example, if A purchases a life insurance policy that is payable to B on A's death, the value of that policy is includable in A's gross estate if she retained, at the time of her death, the ability to change the policy beneficiary to C. If the decedent had no rights to direct or affect economic benefits at the time of her death, then the proceeds of the policy are not includable in the gross estate.

Powers of Appointment Frequently, an individual owns the power to designate who will enjoy an item of property. This power may be considered an attribute of ownership sufficient to be included in the gross estate. The provision 26 U.S.C.A. § 2038, discussed later under retained power, addresses these powers of appointment that individuals reserve to themselves when creating property rights for another individual. Section 2041, in contrast, includes in the gross estate the value of property subject to a "general" power of appointment that the decedent acquired from another person. A general power of appointment is one that individuals may exercise in their own favor or in favor of their estate, their creditors, or the creditors of their estate. If the decedent may only exercise the power in conjunction with either the creator of the power or a person having an adverse interest in the property subject to the exercise of the power, then the power is not considered a general power of appointment because the decedent cannot freely control the transfer of the property at the decedent's death, and the property subject to the power is not included in the gross estate. For example, if A dies and leaves B the right to income in a trust, as well as the right to appoint the trust in whatever manner he wishes, then the entire value of the trust is included in B's estate when B dies. If, by contrast, A leaves B the right to income from the trust as well as the right to appoint the trust only to C or C's heirs, then no portion of the trust is includable in B's estate when B dies.

A power that is limited by an ascertainable standard is not a general power, even if it otherwise appears to be a general power. Ascertainable standards include health, education, support, and maintenance. Accordingly, if A dies and leaves B the power to appoint trust principal to herself if it is required for her health, education, support, or maintenance, B's power is limited by an ascertainable standard, and the value of the trust is not included in the gross estate. But if B may invade the trust principal for her "comfort and happiness," B's power is not limited by an ascertainable standard, and the value of the trust is included in B's estate.

Artificial Aspects of the Estate Tax System Before 1976, the gross estate included the value of all gifts made in contemplation of death. Because determining whether a gift was in contemplation of death turned out to be subjective, difficult to prove, and somewhat morbid, a 1976 amendment to the estate tax law automatically included any gift that a decedent made within three years of death (26 U.S.C.A. § 2035(a)). Unfortunately, the effect of § 2035(a) was to include in the gross estate the full value of the transferred property at the date of death, including any appreciation in value since the transfer. Thus, if A transferred $3,000 worth of stock to B in 1978 and died in 1980, when the stock was worth $25,000, the stock's full value of $25,000 was included in the gross estate, defeating much of A's pre-death tax planning.

In 1981, sweeping tax changes eliminated from the gross estate most transfers made within three years of death. Even so, three specific types of transfers—transfers with a retained life estate, transfers with retained powers, and transfers effective on death—are included in the gross estate because the decedent owned an interest in the property at the time of death. Moreover, the value of property once subject to certain retained interests is included in the gross estate if the release or lapse of the retained interest takes place within three years of death, because the disposition of the retained interest is considered a substitute for disposition at death.

Transfers with a retained life estate Transfers with a retained life estate are covered in 26 U.S.C.A. § 2036. For purposes of the estate tax laws, the term life estate includes more than just an expressly retained life interest in property. For example, if A creates a trust for the benefit of B but retains the right to receive the income from the trust for the rest of her life, her retained income interest clearly is a retained life estate in the property. But the retention of the right to change the economic benefit derived from the property also constitutes a retained life estate, as when A reserves the right to change the trustee and appoint herself the trustee. It also might include retained life estates by tacit agreement, such as when A transfers her home to B, with the understanding that A and not B will live there for the rest of her life.

The mere possession of a life estate in property is insufficient to bring it into the gross estate under § 2036. The life interest must be retained by the decedent and must apply to an interest in property that the decedent transferred. Thus, a life income interest created by someone other than the decedent is not includable in the gross estate under § 2036.

Transfers with retained powers Transfers in which the decedent owns, at the time of death, the power to alter, amend, revoke, or terminate the enjoyment of the property are covered in 26 U.S.C.A. § 2038(a)(1). In contrast to § 2041, which allows general powers of appointment, § 2038 includes only powers associated with a property interest that the decedent gave away during his or her lifetime. The most commonly encountered retained powers are the powers applicable to a revocable trust. A revocable trust is a legal instrument through which an individual relinquishes legal ownership over the property to the trustee of a trust, either retaining to himself or herself beneficial enjoyment of the property, such as the right to income, or granting it to another individual. As its name indicates, the revocable trust is set up so that the creator, known as the grantor, the settlor, or the trustor, may revoke the trust entirely, may change the terms of the trust, or may change the beneficial ownership in the trust.

The creation of, or an addition to, a revocable trust almost never constitutes a gift. A gift must be completed in order to be taxable; the creation of or an addition of property to a revocable trust is, by definition, incomplete because the creator may change the beneficial enjoyment at some time, effectively withdrawing the "gift." Distributions from a revocable trust may, however, constitute completed gifts. For example, if A transfers $2 million to a revocable trust that pays income to B, the transfer of the $2 million is not a completed gift, but the annual payment of $100,000 in interest to B is a taxable gift when it takes place. Upon A's death, the entire value of the property subject to the power, including both the trust corpus and undistributed income payable to B, is included in the gross estate. And, because the property is valued as of the date of death, any increases or decreases in the value of the property since the transfer will appear in the gross estate.

Transfers effective on death The provision 26 U.S.C.A. § 2037 includes in the gross estate the value of transfers that take effect on death. Although at a distance § 2037 seems to apply to all property transfers that occur as a result of an individual's death, the stipulated transfers are rarely encountered. To meet the requirements of § 2037, the beneficiary must be able to acquire an interest in the property only by surviving the decedent. Furthermore, the decedent must have expressly retained a reversionary interest in the property that is worth at least five percent of the property's value at the time of death. Both conditions are difficult to meet. In the first place, the requirement that the beneficiary obtain an interest in the property solely by surviving the decedent is exclusive: If the beneficiary could have obtained an interest in any other way, such as by surviving another individual, satisfying a condition, or outlasting a term of years, the property is not includable under § 2037. In the second place, the requirement that the decedent's retained reversionary interest exceed five percent of the property's value is difficult to satisfy because most retained reversions represent remote interests that reach fruition only if the primary, secondary, and all contingent beneficiaries die first or fail to satisfy the conditions of ownership.

Release or lapse of rights The gratuitous relinquishment or lapse, within three years of death, of a retained life estate under 26 U.S.C.A. § 2036, a retained reversion under § 2037, a retained power under § 2038, or an interest in life insurance under § 2042 will subject the value of the property, subject to the retained interest, to inclusion in the gross estate. This result is a remnant of the pre-1981 policy that transfers "in contemplation of death" should be included in the gross estate. Under § 2035(d)(2), the release or relinquishment of a retained interest within three years of death is conclusively presumed to be "in contemplation of death." Thus, if A transfers his home to B in 1985, retaining the right to live there for life, but abandons that right at the end of 1991, a gift of the remainder interest in the property takes place in 1985, followed by a gift of the relinquished life estate in 1991. But if A dies before the end of 1994, both the 1985 and 1991 gift tax returns will be ignored for estate tax purposes, and the entire value of the home will be included in A's gross estate.

As with the retained life estate, the relinquishment or release within three years of death of a power of appointment retained under § 2038 will cause inclusion of the full value of the property at its date-of-death value. For example, if A creates a revocable trust in 1982, then amends it to make it irrevocable at the end of 1992, a gift will result in 1992 when the trust becomes irrevocable. If A dies before the end of 1995, the entire value of the trust, including any appreciation in value, will be included in A's estate, and the 1992 gift will be ignored. Finally, the release or lapse of ownership or any incidents of ownership over a life insurance policy will cause the entire value of that policy to be included in the gross estate.

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