How The Estate Tax & Gift Tax Work
by Prof. Beckett G. Cantley
Atlanta’s John Marshall Law School
Note: Currently, the Applicable Exclusion allows for $5 million in assets to be transferred during life per person without paying transfer taxes. For married couples, it is not necessary for one spouse to use all of his or her $5 million during life to get the full benefit of the Applicable Exclusion. Instead, the surviving spouse can make use of the deceased spouse's remaining Applicable Exclusion even after the deceased spouse has passed. These rules are scheduled to expire on January 1, 2013, if Congress does not act to extend them. if Congress does not act, on January 1, 2013, the Estate and GST Taxes revert to the form they existed in back in 2001. It is anticipated that Congress will act sometime during 2012 to extend these benefits or otherwise create new benefits that are more generous than the 2001 version. The below article is written from the perspective of the Estate and GST Taxes as they would exist on January 1, 2013, if Congress does not act.
The Federal Estate Tax (“Estate Tax”) and the Federal Gift Tax (“Gift Tax”) are both transfer taxes. The Gift Tax taxes the amount of wealth transferred by a donor during life, while the Estate Tax taxes the amount of wealth transferred by a decedent at the time of his or her death. An overview of each tax and an explanation of how the taxes are interrelated is provided below.
Federal Estate Tax
The Estate Tax is a transfer tax, which taxes the amount of wealth transferred by a decedent at the time of his or her death. The amount of the tax owed is actually determined using a formula, which includes some technical terms defined under the Internal Revenue Code. This formula can be broken down into three parts. The first part of the formula is: Gross Estate less Liabilities and Deductions equals Taxable Estate. The second part is: Taxable Estate times Tax Rate equals Tentative Tax. The third part is Tentative Tax less Applicable Credit Amount (formerly known as the “Unified Credit”) equals Tax Payable. Each part of this formula is described below.
The first step in determining the amount of Estate Tax due is to determine the Gross Estate. The Gross Estate includes the value of all property owned by the decedent at death which passes to someone else by their Last Will and Testament or by intestacy, as well as some life insurance proceeds and some jointly-owned property. The amount of Adjusted Taxable Gifts is also included in the Gross Estate. The Adjusted Taxable Gifts are all of the taxable gifts made during the decedent’s lifetime after December 31, 1976. In addition, the Gross Estate may also include some property gifted by the decedent prior to the decedent’s death if the decedent retained certain controls or “strings” over the property. Thus, the Gross Estate may include property that is not part of the decedent’s “probate estate.”
The next thing that must be determined is what Deductions may be subtracted from the Gross Estate. Such Deductions may include the marital deduction, charitable deduction, and certain expenses. The decedent’s Liabilities are also subtracted from the Gross Estate. After Liabilities and Deductions are subtracted from the Gross Estate, the resulting amount is known as the Taxable Estate.
Next, the Taxable Estate is multiplied by the Tax Rate. The Tax Rate is determined by the Internal Revenue Code, and can be as high as 55%. After this calculation is made, the resulting number is the Tentative Tax.
Applicable Credit Amount
Finally, the Tentative Tax is reduced by the amount of the decedent’s remaining Applicable Credit Amount. In 2011, due to the enactment of the Taxpayer Relief Act of 1997, the Applicable Credit Amount offsets the tax imposed on the first $1,000,000. This resulting number is the Tax Payable.
Federal Gift Tax
The Gift Tax is also a transfer tax. In general, the Gift Tax is imposed when the donor transfers property to the donee without the donor receiving in return consideration in money or money’s worth. There is no “donative intent” requirement for a transfer to trigger the imposition of the Gift Tax. As a result, when the donor transfers an asset to the donee without receiving equal consideration in money or money’s worth, the donor will be taxed, unless the transfer meets one of the exceptions to the general rule. These exceptions include arm’s length transfers (the parties are usually businessmen who are on equal footing in the transaction and are presumed to receive equal consideration), transactions decreed by a court of law (for example alimony), and transactions which are incomplete gifts as determined by the local law.
The value of the gift is fixed at the date the gift is completed. Thus, if the donor transfers something of value to the donee for less than an adequate and full consideration in money or money’s worth, the value of the gift will equal the amount which the value of the property transferred by the donor exceeds the value of the assets received by the donor in return from the donee, on the day of the transfer.
Each donor is permitted to transfer $13,000 per donee on an annual basis without being subject to Gift Tax. Thus, if a single donor has five children, the donor may transfer $65,000 to those children ($13,000 each) each year, without paying any Gift Tax or consuming any of his or her Applicable Credit Amount. This amount, known as the Annual Exclusion is currently increased each year to take account of inflation, due to the enactment of the Taxpayer Relief Act of 1997.
How the Estate and Gift Taxes are Interrelated
As previously noted, each donor is permitted to transfer $13,000 per donee on an annual basis (known as the “Annual Exclusion”) without being subject to Gift Tax or consuming any of his or her Applicable Credit Amount. The Annual Exclusion is currently increased each year to take account of inflation. However, if the amount of the gifts from one donor to one donee in a given year exceeds the Annual Exclusion, then the donor must either pay Gift Tax, at rates ranging from 37% to 55%, or will be forced to apply part of the donor’s Applicable Credit Amount to the otherwise taxable transfer.
While the use of the donor’s Applicable Credit Amount will make the transfer non-taxable (provided the donor still has enough Applicable Credit Amount remaining to cover the entire gift), this consumption of the Application Credit Amount will also reduce the amount of remaining Applicable Credit Amount the donor will have to fund any other lifetime transfers and/or transfers at death. Thus, when the donor dies, the donor will have less Applicable Credit Amount available to cover death transfers. As such, more of the donor’s assets may be exposed to Estate tax than would be had there been no prior use of the donor’s Applicable Credit Amount during life.
An example may help the reader to understand this point. The amount of actual property which can be sheltered by an individual’s Applicable Credit Amount is $1,000,000 for 2002 (known as the “Applicable Exclusion”). If the decedent had made one lifetime gift in a single year to one donee of $33,000, then the donor will only have $980,000 of Applicable Exclusion remaining to cover transfers at death. This result occurs because the first $13,000 of the $33,000 is transferred tax free due to the Annual Exclusion, leaving an otherwise taxable transfer of $20,000. Since the donor must apply $20,000 of his or her existing $1,000,000 Applicable Exclusion, this will reduce the donor’s total $1,000,000 amount by $20,000, leaving only $980,000 to shield all future transfers.