CHAPTER
16

Federal Estate Taxes

In This Chapter

• Taxing estates worth more than $5,450,000
• Computing the federal estate tax
• Marital and other deductions
• Transfers that skip a generation

Note: If your estate is much less than $5,450,000, you can skip this chapter.

So many taxes, and here is the first of them: the federal tax levied on your estate. I know what you’re probably thinking: Isn’t dying bad enough without being hit with a new slew of taxes— in absentia, of course? I couldn’t agree with you more. But for now, that’s the law of the land, and so here they are—estate taxes spelled out.

The Federal Estate Tax: $5,450,000 Estates

First, you should know that officially, the federal estate tax is a levy the federal government places on the transfer of property from the deceased to those who inherit. If $5,450,000 or less is transferred, there is no estate tax for 2016 (unless there have been prior taxable gifts, which I go into later in this chapter). Also, if you leave all your property outright to your spouse or to a charity, there is no federal estate tax at all. (The former is the marital deduction, which I also talk about later.)

The excludible amount increases each year to match the cost of living (well, the Internal Revenue Service’s [IRS] version of that). The highest rate is 40 percent. For 2016, the tax begins at $1 over $5,450,000.

If you’re reading this and thinking Ha, if only I had an estate worth $5,450,000! then I urge you to stop and do some fast math. Do you remember the assets form you filled out in Chapter 1? If you have, for example, a $300,000 life insurance policy and a home valued at $150,000 (although any mortgage would be a deduction from the gross estate), you’re already at $450,000, and we haven’t even touched on your pension and other assets. So do read on. All this could apply to you.

Obviously, the exclusion increases reduce the number of estates required to pay the federal estate tax, but the number will still be significant to your heirs if your estate is one of those over the exempt amount. In 2006, there were 46,050 such estates, which collectively paid $24,652,654,000; in 2012, there were 9,400 returns filed and taxpayers paid $8.5 billion. If Congress feels the need to suspend the increased exclusion amounts, it will do so, if past history is any indication.

Managing Your Wealth to Avoid the Tax

There are ways of handling your “wealth” if you fall into the estate tax asset figure.

Take Ted as an example. When he died in 2016, his wife inherited half of his property ($5 million), and the other half ($5 million) went to their children. Ted had made no substantial gifts in any one year. His estate for federal estate tax purposes is $10 million, but none of it is taxed because $5,000,000 goes to his wife tax free (remember, she’s got that marital deduction) and the other $5,000,000 does not exceed the threshold figure. Looks like Ted did a bit of estate planning.

In addition, any of Ted’s unused estate tax credit is added to his wife’s tax credit. (The IRS refers to this as portability.)

The federal estate tax, incidentally, is paid from the estate before any disbursements are made to beneficiaries or heirs.

What’s Included?

The federal estate tax includes the probate estate and property owned by the deceased, where ownership transfers to another individual upon the deceased’s death. (The spouse gets a marital deduction, remember.)

Let’s use Audrey, a single parent, as an example. She owned the following: her home (worth $500,000) and corporate stock, which she jointly owned with right of survivorship with her daughter Paula (worth $500,000). She also had a life insurance policy ($300,000) with the proceeds payable to her other daughter Diana and a pension (worth $800,000), also payable to Diana. The house is in her probate estate; the stock, life insurance proceeds, and pension amount are transferred to the daughters at Audrey’s death. All the estate is subject to the federal estate tax because it totals $2,100,000, but none is taxed because of the exemption of $5,450,000.

Another Important Figure: $14,000

The amount of $14,000 is mentioned frequently throughout all of Part 4. It’s a common tax break and a good one. Essentially, it is a gift tax exemption. (Chapter 17 goes into much more detail about this gift tax.)

The first $14,000 of any gift you make to any person during any calendar year is excluded from taxation.

If you are married and have a child, you and your spouse can give that child a total of $28,000 per year. Married couples can use those two annual exclusions (worth $12,000 per recipient), even if only one spouse owns the property. This is called gift splitting.

Take Mary, for example. She gives her stock in ABC, Inc., worth $28,000, to her son. If Mary’s husband joins in the gift (and files the appropriate gift tax return), there will be no tax because both parents are using their annual exclusions ($14,000 + $ 14,000). You’ll see the words annual exclusion often in the next five chapters, too; they refer to this $14,000 gift.

The Gross Estate

This is where we begin calculating the federal estate tax. Basically, you take the gross estate, subtract expenses and other allowed deductions, and add certain taxable gifts. At the end of the specific explanations that follow, you’ll see a worksheet. It shows you in numbers the explanations that follow.

Let’s start with our base item, the gross estate. The value of the property on the date of the deceased’s death—the gross estate—generally determines the amount that is subject to federal estate tax.

Here is a list of property that would be included in the gross estate:

• Property solely owned by the deceased.
• Certain gifts transferred within 3 years before death (for example, a life insurance policy ownership transferred to another owner).
• Transfers where the deceased retains a life estate (see Chapter 2) or has the power to revoke the transfer, such as a revocable living trust (see Chapter 9).
• Survivor annuity and survivor pension (when the owner was the first to die).
• Jointly owned property: half is included if it’s jointly owned with the spouse; all is included if it’s owned with another person (and the survivor has made no contribution to the property).
• Property over which the deceased had general power of appointment. What’s this? Look at it this way. I die, and I own some property. I give my wife not the ownership, but the power to give that property to herself or to another individual she wants to have it. This is a rarely used transfer, confined for the most part to pretty sophisticated estate planning in the millions of dollars.
• Life insurance proceeds paid to the estate or where the policy was owned by the deceased. (Most of us own our policies, but someone else could also own an insurance policy on our life.)

So essentially, any property someone else receives because of your death will be included in your gross estate.

I’ll illustrate all of this with Anita’s estate. Anita died in 2008. She was married and had two adult children. According to a prenuptial agreement, Anita’s husband waived any right to her probate estate, so her will leaves the stocks and bonds to her church and the farm to her children. She lived in a non–community property state (see Chapter 3). The following table outlines what Anita owned.

Property	Ownership	Value
House	with husband	$200,000
Household goods	with husband	$20,000
Savings/checking	with husband	$20,000
Stocks and bonds	Anita	$2,800,000
Farm	Anita	$2,800,000
Pension	(husband beneficiary)	$200,000
Mutual fund	paid to church	$200,000
Life insurance	(children beneficiary)	$1,600,000
Total value of the property		$7,840,000

The gross estate for federal estate tax includes the following:

• Half each of the house, household goods, and savings/checking accounts. (The husband is considered to have owned the other half of each asset.) That’s a total of $120,000.
• The stocks and bonds, pension, farm, mutual fund, and life insurance proceeds. That’s a total of $7,600,000.

Therefore, Anita’s gross estate is $7,720,000 ($7,840,000 minus her husband’s $120,000).

Anita had not made any taxable gifts within the last 3 years, such as a life insurance policy, which would have been included in the gross estate, nor had she established a revocable trust, both of which would have been included in her estate for tax purposes. (Most gifts made within 3 years prior to death are not in the gross estate, with a few exceptions noted earlier, and if the gift tax is paid on a gift made within 3 years.)

She had not received from anyone a general power of appointment either.

If Anita lived in a community property state, marital property would be owned as community property, so the surviving spouse’s half interest as his ownership interest in the marital assets would not be part of Anita’s gross estate; it is already his half.

Tax Deductions Allowed

The gross estate is, fortunately, reduced by certain allowed deductions. The most frequently used are the charitable deduction, the marital deduction, expenses of administering the estate, and the deceased’s debts and certain taxes, including any state death taxes paid by the estate. Let’s examine them.

Charitable Deductions

As you have seen, Anita left her mutual fund in the amount of $200,000 to her church, which is, of course, a charity. That entitles Anita’s estate to a charitable deduction. Gifts through a will or a trust, or through life arrangements that are paid by an estate or trust, qualify for this deduction.

The Marital Deduction

Here is a very popular deduction that includes all property the surviving spouse receives outright or through certain qualified marital trusts.

Returning to Anita, we see that her husband received the following:

• Half of their house, half of their household goods, and half of their savings/checking account because they owned each asset jointly with right of survivorship and he survived her. All together, this property totals $120,000. (He already owned the other half of each asset as co-owner.)
• $200,000 as survivor on her pension plan.

The total amount of the marital deduction here is $320,000.

The QTIP and Credit Shelter Trust

Let me explain something else here briefly. Sometimes a husband or wife receives property in trust from the other spouse, where the recipient is the only income beneficiary. If the surviving spouse elects to treat the amount left in the trust by his or her dearly departed as his or hers for the recipient spouse’s estate tax, the marital deduction is available for the deceased spouse’s estate tax. In effect, the recipient receives the income from the trust during life and then the balance of the trust at death is included in the recipient’s estate for the federal estate tax. The surviving spouse would be beneficiary of the trust income and then the principal would go to others (e.g., children) at death.

This is an exception to the general rule that a spouse must receive the property outright to qualify for the marital deduction.

This qualified trust is often referred to as a QTIP (Qualified Terminal Interest Property). There must be an election (choice) to treat a QTIP trust as a marital deduction in the deceased’s estate.

A spouse who has significant assets may want to establish two trusts:

• One trust involves a QTIP (for the marital deduction).
• Another trust, funded with $5,450,000 or the current amount of the exclusion, called a credit shelter trust, is for using the unified credit equivalent amount. (I explain that in the next few pages.)

Combining the QTIP trust with the credit shelter trust could mean the deceased’s estate will not have to pay any estate tax.

The property transferred to the spouse’s QTIP trust provides a marital deduction and the $2 million that is exempt from the tax, the latter of which goes to the credit shelter trust, equal the gross estate. Both trusts could be used to support the spouse during his or her life.

Of course, you can make a gift to your spouse and obtain the same result, except you no longer have any control over what he or she does with the property given.

Deductible Expenses

The estate might have quite a few costs. There could be probate administration expenses (filing, executor, and attorney fees). There could be debts on the estate property, such as a mortgage on the home and bills that were unpaid at Anita’s death. Likewise, there may be taxes Anita would have had to pay, such as income tax on earnings in the year before she died, or property taxes on her real estate. The state death tax credit expired as a credit in 2004 and became a deduction in 2005 and thereafter.

Anita’s estate actually had the following deductions:

Probate expenses	$120,000
State death taxes	$20,000
Mortgage on her farm	$50,000
Income taxes due	$5,000
Property tax on her farm	$5,000
Total	$200,000

Adding It Up

Here are all of Anita’s estate’s deductible expenses:

Charitable	$200,000
Marital	$320,000
Other (mentioned earlier)	$200,000
Total	$720,000

Her whole tax computation looks like this so far:

Gross estate	$7,720,000
(Less) deductions	$720,000
Taxable estate	$7,000,000
Tentative tax	$2,745,800
(Less) tax credit	$2,125,800
Tax to be paid	$620,000

Anita did not make any post-1976 taxable gifts (gifts in excess of the annual exclusion of $10,000 per recipient, or $20,000 if the spouse joins in making the gift, now increased to $14,000 and $28,000). Therefore, her tax base is the same as her taxable estate.

If there are gifts in excess of the annual exclusion, they would be added to the tax base. For example, if Anita had given $50,000 to one of her children in 2016 (and her husband joined in the gift), the taxable portion of the gift would be $22,000 (the $50,000 gift, less the $28,000 annual gift exclusion for both of them).

40 Percent Beginning Rate

Now we’re getting to the important numbers. The federal estate tax rate is 40 percent. That means Anita’s highest marginal rate is 40 percent.

Anita’s taxable estate is $7 million based on the following table, and her tax computation looks like this:

$345,800 (on the first $1 million) at 39 percent

A tax rate of 40 percent of the next $6,000,000, or $2,400,000 in estate tax

This tax of $2,745,800 is computed using the IRS estate tax table.

Tax Rates and Exemptions for Federal Estate Tax

Year	Tax Rate	Exemptions
2002	50%	$1 million
2003	49%	$1 million
2004	48%	$1.5 million
2005	47%	$1.5 million
2006	46%	$2 million
2007	45%	$2 million
2008	45%	$2 million
2009	45%	$3.5 million
2010	Top Individual Rate	Unlimited—Taxes Repealed (for gift tax only)
2011	35%	$5,000,000
2012	35%	$5,120,000
2013	40%	$5,250,000
2014	40%	$5,340,000
2015	40%	$5,430,000
2016	40%	$5,540,000

The following table shows the estate tax rates for estates over the exemption amount after the changes in the Tax Act of 2001.

Tax Rates for Federal Gift Tax and Federal Estate Tax

If the Amount with Respect to Which the Tentative Tax to Be Computed Is …	The Tentative Tax Is …
Not over $10,000	18% of such amount
Over $10,000 but not over $20,000	$1,800 plus 20% of the excess of such amount over $10,000
Over $20,000 but not over $40,000	$3,800 plus 22% of the excess of such amount over $20,000
Over $40,000 but not over $60,000	$8,200 plus 24% of the excess of such amount over $40,000
Over $60,000 but not over $80,000	$13,000 plus 26% of the excess of such amount over $60,000
Over $80,000 but not over $100,000	$18,200 plus 28% of the excess of such amount over $80,000
Over $100,000 but not over $150,000	$23,800 plus 30% of the excess of such amount over $100,000
Over $150,000 but not over $250,000	$38,800 plus 32% of the excess of such amount over $150,000
Over $250,000 but not over $500,000	$70,800 plus 34% of the excess of such amount over $250,000
Over $500,000 but not over $750,000	$155,800 plus 37% of the excess of such amount over $500,000
Over $750,000 but not over $1,000,000	$248,300 plus 39% of the excess of such amount over $750,000
Over $1,000,000	$345,800 plus 40% of the excess of such amount over $1,000,000

Source: Internal Revenue Service

But wait a minute. Anita has several tax credits available. First, there is what is known as the unified tax credit. That’s a lifetime tax credit of $5,450,000 on gifts or $5,450,000 on your estate in 2016. Over the years, if you make gifts, that credit is reduced according to the size of those gifts. Indeed, at your death, you may have used up the credit so it won’t be there to benefit your estate.

Anita’s estate tax was $620,000. That’s the absolute bottom line. You think that’s a lot to owe? Keep in mind the original amount of Anita’s estate—more than $7,840,000.

If you are still unhappy with estate tax, you might read Chapter 20, which, among other tips, provides some valuable estate tax avoidance information.

If you don’t plan to make a gift in your will of more than $5,450,000 in 2016 to your grandchildren, you can skip this section.

Suppose Keith wants to skip the next generation (his child) and leave all his money to the second generation (his grandchildren). He figures his daughter’s estate is large enough already to be taxed when the time comes, so why leave his daughter money that will only be added to her estate tax?

Unfortunately for Keith and other taxpayers, Congress has thought about that, too. The generation-skipping transfer tax (GSTT) is imposed when the next generation (the kids) is bypassed in favor of a later generation (the grandkids). The tax applies to gifts and transfers by death, and the current tax rate is 45 percent.

Now, each person has a $5,450,000 exemption from the GSTT in 2016. A husband and wife could transfer $10.9 million through gifts and devises in their wills to their grandchildren free of the GSTT.

Please note that the GSTT exclusion increases at the same amount as does the estate tax exclusion. Thus, in 2016, the GSTT exclusion increases to $5,450,000 and follows the estate tax thereafter. However, an estate or gift tax may still apply.

The Least You Need to Know

• In 2016, estates more than $5,450,00 may be subject to the federal estate tax.
• A gross estate for tax purposes includes all property transferred to someone else because of death.
• Thanks to the marital deduction, property going outright to a spouse is not taxed.
• The federal estate tax begins at 40 percent.