Chapter 13 Gift and Estate Planning – The Basics

1. Chapter 13Gift and Estate Planning – The Basics ©2010 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com

2. Gift and Estate Tax Planning - The Basics • The Unified Transfer Tax System - How does it work? • In general the transfer tax system applies to transfers of property whether during the donor’s lifetime (gift) or at death (estate) which are made for less than full and adequate consideration in money or money’s worth. • Federal estate and gift taxes are computed as part of one unified transfer tax scheme; the same tax rate schedules and unified credit apply to both. • The tax base = The cumulative total life-time and death transfers at fair market value • Fair market value is “defined as that price at which property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell.” • How is a property’s fair market value determined? • Answer: Depends on the property being valued. • Comparable retail price. • Publicly traded securities – trading price on date of gift or death. • Securities subject to intermittent sales are valued using a weighted average based on the days around the valuation date. • Notes receivable are valued at fair market value taking into account their terms, collateral and other factors. • Assets without a ready market should be appraised.

3. The Federal Gift Tax • How is the gift tax computed? • The gift tax base is life-time transfers of property for less than full and adequate consideration in money or money’s worth. • The current year’s gift tax liability is computed by determining the tax due on total cumulative life-time gifts as reduced by the unified credit amount and previous gift taxes paid. • The unified credit is first used to offset any gift tax liability (a dollar for dollar reduction) before any amount is due. • The unified transfer tax credit for life-time gifts is $345,800 (the equivalent of tax-free life-time transfers of $1 million). • The result is the incremental tax due on the gifts made during the current tax year. • What are the gift tax filing requirements? • The federal gift tax return (Form 709) is due on or before April 15 of the year following the year of the gift. • A Form 709 must be filed if the donor made gifts of present interests with a value greater than $13,000 in 2010 and/or a gift of a future interest of any value. • A Form 709 must be filed to if the donor is consenting to split gifts with his or her spouse.

4. Transfers Subject to Gift Tax • Which property transfers are subject to the gift tax? • Transfers of property whether direct or indirect, in trust or otherwise. • The property transferred can be real or personal property, in tangible or intangible form. • An incomplete transfer or one that is revocable is not a completed gift subject to the gift tax. • Query: Is the right to receive payment in the future (such as an installment note) a property right subject to the gift tax or is it an incomplete gift? • Answer: Yes, the transfer can be of any type of property right legally recognizable as such. The key question to ask is whether the donor has transferred an interest in property which is capable of valuation and over which he has relinquished complete dominion and control? If the answer is yes, there is a completed gift subject to gift tax.

5. Completed Gifts - Examples • Query: What are some examples of completed gifts? • Answer: • A bargain sale or purchase of property. • A release of a general power of appointment. • The forgiveness of debt, especially between related parties. • The giving of a below market rate loan, especially between related parties. • Creation of a joint tenancy may result in a taxable gift. • The gift is equal to the difference between the value of the property interest created in the joint tenant and the amount the tenant paid to acquire the property, if any. • Note creation of a joint bank account is not a completed gift as the donor/owner may withdraw all the funds at any time. However, the withdrawal of funds by the non-contributing joint tenant in excess of amounts he paid for the property is a completed gift.

6. Excluded Gifts • Some gifts are excluded from the gift tax base. • Qualified transfers of property in payment of medical expenses of another (including someone unrelated to the donor) when paid directly to the service provider of medical care. • Qualified transfers of property in payment of the educational expenses of another (including someone who is unrelated to the donor) when paid directly to a qualifying educational institution for tuition. • Transfers of money or other property to qualifying political organizations which are for the use of the organization. • Transfers of property to qualifying charities, provided that no contingencies or conditions apply to the charity’s receipt of the property.

7. Federal Gift Tax – The Annual Exclusion • In 2010, the first $13,000 ($26,000 if spouses consent to split-gifts) of gifts made to each donee during the calendar year is excluded from the taxable gifts. • The annual donee exclusion is limited to the actual value of the gifted property, if less than $13,000. • The transferred property must be that of a present interest. • What is a present interest in property? • A present interest is an unrestricted right to the immediate use, possession, or enjoyment of property or the income therefrom. • A future interest does not qualify for the annual exclusion. • What is a future interest? A reversion, a remainder or other interest in property, whether vested or contingent, which is not available for the beneficiary’s use, possession or enjoyment until some future date or time. • Query: Can contributions to an irrevocable trust qualify for the annual exclusion even if no income can currently be paid from the trust, or do the contributions constitute a gift of a future interest because possession or enjoyment is delayed to a future time? • Answer: Yes, if the trust instrument contains a provision that permits a beneficiary, upon sufficient notice to demand withdrawal of principal amounts up to the lesser of (1) the amount contributed to the trust or (2) the annual donee exclusion. This is known as a Crummey demand power.

8. Federal Gift Tax – Deductions • What deductions are permitted in computing net taxable gifts? • The Marital Deduction permits unlimited transfers of property for less than full and adequate consideration, not characterized as terminable interests, to a spouse without gift tax consequences. • What is a terminable interest? • It is a gift that lapses or fails because of the occurrence or non-occurrence of an event or contingency or the passage of time, such as a life estate or a term of years. • A terminable interest granted to a spouse does not qualify for the marital deduction because the donor-spouse retains an interest in the property or grants to some person other than the donee/spouse an interest in the property or the right to determine who can possess or enjoy all or a portion of the property after the donee-spouse’s interest ends. • The Charitable Deduction - A donor is permitted an unlimited charitable deduction for gifts made during the calendar year to qualified charitable organizations, provided that the property is to be used by the qualifying charity for public purposes.

9. Gift-Splitting Elections • Married couples may consent to split all gifts made by one spouse to a 3rd party during the calendar year. • If gift-splitting is elected the spouses treat each gift made by either spouse during the calendar year as made one-half by each, effectively increasing the annual per donee exclusion to $26,000 for married couples. • What requirements must be met to split gifts? • The spouses must be married at the time of the making of the gift and the donor spouse must not remarry during the remainder of the calendar year; • Both spouses must be U.S. citizens or residents; • Both spouses must provide their consent to split all gifts each made by the other during the calendar year.

10. The Federal Estate Tax • Determining the Gross Estate • An individual’s gross estate is comprised of the fair market value of all property in which the decedent had an ownership interest or the right to control at his death. • Property is generally valued at its fair market value on the decedent’s date of death. • The alternate valuation date - A special election allows the executor or administrator of the estate to elect to use an alternate valuation date, exactly six months from the date of the decedent’s death, to value property. • The alternate valuation election is permitted only if: • It will decrease the gross estate, and • It will result in a decrease in the estate tax due. • If the alternate valuation date is elected and property is sold or disposed of within the six month period, the sale’s price or fair market value on the date of disposition is deemed the property’s fair market value. • What are the federal estate return filing requirements? • An estate tax return (Form 706) must be filed within 9 months of the decedent’s date of death if the decedents estate plus adjusted lifetime gifts is greater than the exemption equivalent or $3.5 million in 2010. • Note current law provides for a repeal of the current estate tax scheme (not the gift tax) in 2010 and then a reintroduction in 2011 applying the estate tax system in place in 2002.

11. Estate Valuation – Special Cases • Joint Interests in property are those in which the decedent’s interest is not a whole. When are partial interests included in the decedent’s gross estate and how are such partial interests valued? • The valuation and inclusion of a joint property interest in the gross estate is dependent on how title to the property is held. • Joint Tenancy with Rights of Survivorship (JTWROS) • If the joint tenants are not spouses, the entire value of the property is included in the estate of decedent joint tenant reduced by the surviving joint tenant’s cost contribution percentage. • If joint tenants are spouses, one-half the value is included in the decedent’s estate. • Tenancy by the Entirety Property is essentially joint tenancy property between a husband and wife (an interest created under state law); and thus, 50 percent of the total value is included in the decedent spouse’s estate. • Tenants in Common property is owned by more than one individual in varying percentages or shares, thus, only the value of the decedent’s interest is included in the gross estate.

12. Estate Valuation – Special Cases(Cont’d) • Community Property – each spouse has an equal interest in property of the marital community and death does not alter that ownership interest; therefore, one-half the value of community property is included in the decedent’s gross estate. • Life Insurance Policies inclusion depends on the decedent’s interests in the policy. • If the decedent owned a policy on the life of another, the value of the equivalent replacement cost is included in the gross estate. • Proceeds payable on the death of the decedent are includible in the gross estate if: • Payable to the decedent’s estate or to another for the benefit of the estate, • The decedent held significant incidents of ownership in the policy, such as the right to change beneficiaries or borrow against the policy. • The face value of any policy previously owned by the decedent and transferred to another within three years of death.

13. Federal Estate Tax:Deductions, Exclusions and Computation of Tax Due • What deductions are permitted in computing the decedent’s gross taxable estate: • An unlimited marital deduction is allowed for transfers of property to a surviving spouse (other than terminable interests, unless the interest is a qualifying terminable interest). • A charitable deduction is allowed. • Administration expenses including legal and accounting fees, and probate costs are deductible. • Debts of the decedent. • Casualty and theft losses incurred during administration. • Expenses of the decedent’s last illness (paid after death) if not deducted on the estate’s income tax return. • Funeral expenses.

14. Federal Estate Tax:Deductions, Exclusions and Computation of Tax Due (Cont’d) • How is the estate tax computed? • On a cumulative basis by adding to the gross taxable estate the total adjusted life-time gifts (those made after 1976). • The unified transfer tax due is then computed on the aggregate using the unified rate schedule (the same schedule used for life-time transfers). • Against this transfer tax liability various credits are allowed. • The Unified Credit of $1,455,800, in 2010, is available to offset the transfer tax due at death (This is the equivalent of transferring assets with a value of $3.5 million without incurring an actual liability.) • A credit is allowed for prior gift taxes paid to prevent taxing the same transfers twice. • A credit is also allowed for prior estate transfer taxes paid if property is included in the decedent’s estate that was also included in the estate of another within the past ten years. • The credit is 100% the lesser of (1) the marginal estate taxes due on the current decedent’s estate tax return or (2) the estate taxes paid on the prior return. • The credit is phased-out for every two years after the death of the current decedent that the transfer was previously included in another estate. • A state death tax credit was previously allowed for state death taxes paid; however, currently only a deduction is permitted. • A credit is available for foreign death taxes paid.

15. The Generation Skipping Tax (GST) • What is the GST? • To prevent a loss of transfer tax revenue that would result if transfers skipped a generation (for example a transfer from grandparent to grandchild loses the layer of tax imposed on the transfer from parent to child) Congress created the Generation Skipping Tax. • The tax is computed on the value of transfers that skip a generation using the highest marginal gift tax or estate tax rate (The highest marginal rate is currently 45%.) • It is imposed only when the Treasury loses the opportunity to impose the estate (or gift) tax on a generational transfer of property. • A GST exemption equal to the estate tax unified credit is currently available ($3.5 million in 2010). • What is an example of a transfer subject to the GST? • Henry Jobs creates a trust by his will (a testamentary trust) which pays income for life to his wife Betty Jobs, and on her death, income is payable to his grandchildren, Myrtle and Myron, until they reach the age of 25 at which time the trust principal is distributed to them outright. Because the remainder interest passes directly to the grandchildren and by-passes Henry’s children, this is an example of a generation skipping transfer.

16. Planning Basics – Lifetime Gifts • What planning techniques could be used to minimize the lifetime transfer tax liability imposed on gifts? • Maximize the Use of the Annual Exclusion and Unified Credits • Life-time gifting tools that can reduce transfers taxes include maximizing the benefits of the annual exclusion by spreading gifts over several years. • Married couples can elect to split gifts to maximize the annual exclusion. • Married couples with disparate estates can use life-time tax-free gifting to equalize their estates and take fullest advantage of their combined unified credits. • Gifting appreciated property (and property that is believed will continue to appreciate) removes that future appreciation from the gross taxable estate. • If the value of the property is significant, partial interests can be gifted over a number of years to maximize the use of the annual exclusion and gift-splitting.

17. Lifetime Gifts – Basis Considerations • The basis of gift property to the donee is a dual basis depending on whether the property is sold for a gain or loss by the donee. • If the amount realized on the sale exceeds the property’s adjusted basis at the time of gift and the property is sold for a gain, the donee’s basis is a transferred basis (carryover basis); that is the adjusted basis of the property in the hands of the donee. • If the amount realized on the sale is less than the property’s adjusted basis at the time of gift, and the property is sold for a loss, the donee’s basis is the lesser of the property’s (1) FMV or (2) adjusted basis at the time of gift. • If the amount realized is between the property’s adjusted basis and fair market value, no gain or loss is recognized and the property’s basis is presumed to be the amount realized. • Holding period issues: • If the donee’s basis is determined by reference to the donor’s basis, the donor’s holding period is tacked on to that of the donee. • If the donee’s basis is determined by reference to the property’s fair market value the donor’s holding period is ignored. • Adjustment for gift tax paid: • For gifts made prior to 1977, the entire gift tax paid is added to the donee’s basis but the total is limited to the property’s fair market value. • For gifts made after 1976 the gift tax added to the basis is related to the appreciation in value as follows: Addition to basis = Gift tax paid * (Appreciation/FMV on date of gift).

18. Lifetime Gifts – Basis Considerations (Cont’d) • The basis of property received through inheritance is generally the property’s fair market value on the date of death unless the alternate valuation date (exactly 6 months after the date of death) is elected. • The holding period of inherited property is automatically long-term. • Planning: Would a beneficiary prefer to receive property by gift of by inheritance? • Answer: In general beneficiaries prefer a step-up in basis for appreciated property. • If however, the property is loss property, it may be best for the donor to sell the property and recognize a tax loss followed by a gift of the proceeds to the donee.

19. Other Life-time Planning Tools • Use life-time gifts to shift income-producing assets to lower-bracket taxpayers (benefit minimized by the allocable parental tax.) • In general a lifetime gift to charity is more advantageous than a gift at death, because the life-time gift produces an income tax deduction. • Use the unlimited marital deduction, to equalize the disparate estates of spouses to maximize the benefit of their combined unified credits and to reduce their overall transfer tax liabilities. • To exclude the value of a life insurance policy from the estate, the decedent must transfer all incidents of ownership to another person or entity at least three years before his or her death. • This is commonly done through an irrevocable life insurance trust coupled with a Crummey demand power. • Minimize probate court costs by titling assets in ways that property will pass by operation of law (that is, automatically without any action being required by the Probate Court). • Use a revocable living trust to avoid probate. • With a revocable living trust, the grantor transfers property to a trust with the income and principal payable to or for the benefit of the grantor (and/or his spouse) during his life time. At the death of the grantor the trust becomes irrevocable and the property passes to designated beneficiaries as directed by the terms of the trust. As property passes by the terms of the trust, probate is not required.

20. Optimizing the Estate Tax Marital Deduction • What role does the unlimited marital deduction play in estate planning? • The estate tax marital deduction can be used to equalize the taxable estates of the spouses and minimize their overall transfer tax burden. • The Marital Deduction may be underfunded through intestate succession. • In most states intestate succession creates dower or curtesy rights in the surviving spouse. If there is a surviving spouse and children, in most states the surviving spouse receives 1/3rd the decedent’s estate and the children 2/3rd. • The way around this is for the children to disclaim that portion of the estate in excess of the credit shelter amount in favor of the surviving spouse, leaving it to pass by the marital deduction to equalize estate taxes on the 2nd to die. • What is a qualified disclaimer? • A qualified disclaimer is an irrevocable and unqualified refusal to accept an interest in property such that the disclaimant is treated as never having received the disclaimed property and is not treated as having a made a gift of the property to the alternate recipient. • The marital deduction may be overfunded through excessive transfers. • If the decedent leaves all of his property to the surviving spouse to avoid taxes on the first death, the combined estates of the decedent and surviving spouse will be bunched on the 2nd to die, wasting the decedent’s unified credit. • To avoid this result, the surviving spouse should disclaim in favor of the couples’ children or other beneficiaries up to the amount of the decedent’s unified credit.

21. Fine-Tuning the Marital Deduction: A “Reduce to Zero” Formula in a Will • What is a reduce to zero clause? • A reduce to zero clause is a will provision that requires that the marital deduction property allocated to the surviving spouse be that amount which reduces the decedent’s gross taxable estate (after taking into account all other deductions and credits available to the estate) to an amount which equals the equivalent of the unified credit for the year of death, and thus, the estate tax to $0. • One way to satisfy a “reduce to zero bequest” is through use of a by-pass trust or credit shelter trust (that is the funds by-pass the spouse and eventually go to the children or other designated beneficiaries.) with the balance of the property funding a marital deduction trust. • A marital deduction trust can provide an income interest (and principal as needed) to a surviving spouse with the remainder to the children on the surviving spouse’s death. • However, if the surviving spouse’s interest terminates at her death, the property will not be included in her estate because the grantor retained the ultimate power to direct who would possess the property on the death of the surviving spouse. • To protect against this escape from taxation (a marital deduction to the decedent spouse’s estate without inclusion in the surviving spouse’s estate), the Code denies a marital deduction for a transfer of a terminable interest. • Recall that a terminable interest property is a transfer of property that lapses or fails because of the occurrence or non-occurrence of an event or contingency or the passage of time. A terminable interest generally takes the form of a life estate or a term of years.

22. Fine-Tuning the Marital Deduction: A “Reduce to Zero” Formula in a Will (Cont’d) • What are two ways to structure marital deduction trusts, although the surviving spouse’s interest qualifies as a terminable interest, so that it receives the benefit of the marital deduction and is included in the estate of surviving spouse? • Through a power of appointment trust or a QTIP trust. • A power of appointment trust meets the following requirements to qualify for the marital deduction: (1) the surviving spouse is entitled to receive all of the income from the entire trust property or a specific portion for life; (2) the income is required to be paid to the surviving spouse annually or at more frequent intervals and (3) the surviving spouse must have the power to appoint the entire interest or specific portion thereof in favor of the surviving spouse and/or the spouse’s estate although it may also be exercisable in favor of others, as well. • A QTIP (qualified terminable interest property) election allows the decedent’s estate to take a marital deduction with inclusion of the trust proceeds in the estate of the second spouse to die, if the following conditions are met: (1) the surviving spouse has a “qualifying income interest”, which is an immediate right to all of the income from the property or a specific portion thereof, (2), the income is payable annually or at more frequent intervals, and (3) no person, including the surviving spouse has the right to appoint the property to any one other than the surviving spouse during his or her lifetime.