The Gross Estate

Terms:

Fair market value:
“The price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Treas. Reg. § 20.2031-1(b).

Record date:
The date on which a person must be registered as a shareholder on the stock book of a company in order to receive a declared dividend. Dividends are paid on the payment date to those who own the stock on the record date.

Date of declaration:
The date when a dividend is formally declared (approved) by the board of directors.

Ex-dividend:
Term used by stockbrokers, meaning that a sale of corporate stock does not carry with it the seller’s right to receive his proportionate share of a dividend already declared and shortly payable.

Closely held corporation:
A corporation whose shares are held by a single shareholder or closely-knit group of shareholders. Generally, there are no public investors (i.e., not listed on a stock exchange) and its shareholders are active in the conduct of the business.

Joint tenancy:
Type of ownership of real or personal property by two or more persons in which each owns an undivided interest in the whole and attached to which is the right of survivorship (a right to receive the property upon the death of the other).

Tenancy by the entirety:
A tenancy which is created by a husband and wife and by which together they hold title to the whole with right of survivorship. When one dies, the other takes full ownership. Neither party can alienate (transfer the title to property) or encumber (take out a mortgage or lien) the property without the consent of the other.

Tenancy in common:
A form of ownership whereby each tenant (i.e., owner) holds an undivided interest in the property. Unlike a joint tenancy or a tenancy by the entirety, the interest of a tenant in common does not terminate upon his or her prior death; there is no right of survivorship.

General Power of Appointment:
A power over assets held by a person, that allows that person to determine what happens to those assets.

The gross estate consists of the value of all property (real or personal, tangible or intangible) owned by a decedent or in which the decedent had an interest at the time of death. See I.R.C. § 2001(b)(2). Generally, assets are included in the gross estate at their fair market value on the date of the decedent’s death. As an alternative, an alternate valuation date can be used—within six months of the decedent’s date of death. See I.R.C. § 2032(a). Whichever method is chosen, all assets must be valued on the same basis—either all at the date of death or all at the alternate valuation date.

Real Property

Real property, whether located in the state of residence or out-of-state, owned by the decedent on the date of death, is includable in the gross estate. Common types of real property interests are: a personal residence, a vacation home, rental property or a condominium. In addition, if the decedent had contracted to purchase real property (and died before the closing), the property subject to the contract is includable in the gross estate. If there is a mortgage on the property, however, the amount of the mortgage is deductible as a decedent’s debt.

To determine the value of the property, Treasury Regulations specify that one has to look at the “highest and best use,” possible for that property, regardless of the actual use, which could be of lower value. See Treas. Reg. § 20.2031-1. To address a possible unfairness issue, Congress carved out certain exceptions to this general rule. For example, a personal representative may elect a special use valuation of real property that is used for farming or for any other closely held business. See I.R.C. § 2032A. Property that falls under these exceptions will be valued for estate purposes on the basis of its actual use and not its highest and best fair market value use, thus decreasing the gross estate. However, the maximum reduction allowed for these exceptions is set at a little under $1,000,000.( It varies from year to year.) For example:

Jared owned thousands of acres in rural North Carolina that he used for farming. The land had been in his family for three generations. Although the surrounding area had seen an explosive growth in commercial development over the years, Jared refused to sell his property to developers. As farmland, it was worth $1,000,000. If the land had been used for commercial purposes, it would have been worth $1,840,000. When Jared recently died, he left the land to his son, Patrick, who also worked the farm with him. To minimize the estate tax bite, Patrick, as the executor of the estate, can elect special use valuation of the land to value it for estate purposes on the basis of its actual rather than at the higher, best fair market use. For 2003, the maximum decrease in the estate value under this election is $840,000. So, the transfer, for estate tax purposes, would be considered only $1,000,000.

Stocks and bonds

Stocks and bonds of any kind, whether issued by domestic or foreign corporations or governments, are includable in the gross estate. If the decedent died on or after the record date but before the payment date, the dividend is includable as a separate asset because the decedent (via his estate) is still entitled to the dividend. If the decedent died after the stock goes ex dividend but before the record date, the amount of the dividend is added to the value of the stock. Accrued interest (from the last payment date to the date of death) on bond and notes are also included in the estate.

Mortgages, notes and cash

Mortgages and notes, whether secured or unsecured, are generally valued at face value, less principal payments made prior to death; interest accrued from the last payment date until the death is also included. For example:

Jared owned thousands of acres in rural North Carolina that he used for farming. The land had been in his family for three generations. As Jared neared retirement age, he wanted to find an easier way to generate income from the land. The years of hard work had taken a toll on his body. Since his son-in-law, Adam, also worked the farm with him, he sold it to him and financed the purchase so he could continue to have an income stream. At his death in mid-May 2003, Adam owed $550,000 at 6% interest per annum compounded monthly. The note’s face value ($550,000) will be included in Jared’s estate. In addition, the accrued interest (approximately $1,375) from the beginning of May until his mid-May death will also be included in the estate.

Cash, savings, checking accounts and certificates of deposit (CD) are includable at their date of death values. For interest bearing accounts (e.g. savings accounts), the interest amount is includable in the estate as long as the decedent is entitled to the interest at the time of his or her death.

Insurance

Life insurance proceeds are includable in the gross estate if:

  • the estate of the decedent is the beneficiary of the policy; or
  • the beneficiary has a legally binding obligation to use the proceeds for the benefit of the decedent’s estate; or
  • the decedent possessed, at his or her death, any “incidents of ownership,” which the decedent could have exercised at the time that he or she died.

See I.R.C. § 2042. “Incidents of ownership” includes the right to cancel the policy, cash in the policy, change the beneficiary, assign the policy, borrow against the cash value or pledge the policy. See Treas. Reg. § 20-2042-1(c)(2). Thus, most insurance policies purchased by a decedent will be includable in his or her gross estate.

Example: Jared purchased a $50,000 life insurance policy on himself. His late wife, Carol, was the primary beneficiary; his son, Patrick was the secondary or "contingent" beneficiary. The policy did not allow Jared to change the designation of the beneficiary or the other terms in the policy in any way whatsoever. Jared recently died and the life insurance policy was still in force. Since one of the beneficiaries of Jared’s policy (Patrick) is still alive, Patrick will receive the $50,000 proceeds, which will not be included as part of Jared’s estate.

Example: Jared purchased a $50,000 life insurance policy on himself. His late wife, Carol, was the primary beneficiary; and there was no secondary beneficiary. The policy did not allow Jared to change the designation of the beneficiary or the other terms in the policy in any way whatsoever. Jared recently died and the life insurance policy was still in force. Since Jared’s beneficiary predeceased him, the $50,000 proceeds will now go to his estate and, therefore, be included in his assets for estate tax purposes.

Sometimes individuals own policies on others’ lives, such as spouses or children. In those cases, if the decedent owned insurance policies on the life of another, the insurance is taxed in the decedent’s estate at the policy’s “replacement value” (what the policy could be bought for at that time). See Donaldson v. Commissioner, 31 T.C. 729 (1959); I.R.C. § 2033.

Moreover, decedents could have life insurance policies through a business held by the decedent (a “closely held” business). If a decedent was the sole or controlling (more than 50% of the voting power) shareholder of a corporation, the corporation’s “incidents of ownership” (discussed above) will be attributed to the decedent. In other words, if the decedent owned all of or most of a business and the business owned the insurance policy, then the decedent will be considered the owner of the policy. But, if the policy is for a business purpose (e.g. to use the proceeds to finance a business belonging to a person after that person dies), then the policy will not be considered to have belonged to the decedent.

Example: Jared owned thousands of acres in rural North Carolina that he used for farming. The land had been in his family for three generations. His son-in-law, Adam, also worked the farm with him. Both are 50% owners of a farming corporation that owns their farming business. Years ago, Jared had purchased a $50,000 life insurance policy on himself. His late wife, Carol, was the primary beneficiary; Jared did not have a secondary or contingent beneficiary. When Adam entered the business with Jared, both purchased additional $500,000 life insurance policies, naming the corporation as the beneficiary. As part of an agreement between Jared and Adam, the proceeds were to be used to pay off the family of the person who died first, thereby making the other person the sole owner of the business. Jared recently died and all life insurance policies were still in force. Since Jared’s beneficiary on his personal life insurance policy predeceased him, the $50,000 proceeds will now go to his estate and be included in his assets for estate tax purposes. Since the beneficiary on the $500,000 policy is the corporation, the $500,000 will not be included in Jared’s estate because the money is for a valid business purpose.

Jointly held property

Generally, the full value of any property owned by the decedent as a joint tenant with a right of survivorship with another person is includable in the decedent’s gross estate. The full inclusion amount can be reduced by the amount contributed by the surviving tenant (the other person owning the tenancy) to acquire the asset. See I.R.C. § 2040(a). For example:

Ron and Jacob owned Blackacre as joint tenants with rights of survivorship. Blackacre is worth $500,000. When Ron dies, the full $500,000 is included in his gross estate. However, if Ron’s estate can show that Jacob paid $200,000 toward Blackacre’s purchase, only the remaining $300,000 will be included in Ron’s estate.

The rule changes slightly for a joint interest classified as a “tenancy by the entirety” (a kind of joint tenancy with a right of survivorship owned by the decedent and his or her spouse as the sole joint tenants). In a tenancy by the entirety, only one-half of the value of the jointly owned asset will be included in the gross estate of the first joint tenant (first spouse) to die. In this instance, it is irrelevant which spouse provided the money to purchase the asset in the first place. See I.R.C. § 2040(b).

Example: Julie and Jacob were married 45 years ago. Shortly after the wedding, they purchased a three bedroom colonial home in suburban Chicago for $23,000. Recently, Julie suffered a stroke and died. Since their two children were grown, Jacob no longer needed such a big house for just himself. So, he sold it to a young couple for $330,000. Since this home is owned in a tenancy by the entirety, only one-half of the value ($165,000) is included in Julie’s estate.

As previously discussed, there is an unlimited marital deduction to offset estate tax. As such, the inclusion of this one-half interest in the gross estate of the first spouse to die will not negatively impact the surviving spouse’s estate tax liability. One drawback, however, is that the basis will be affected. Since only one-half of the value of the jointly held property will be included in the gross estate for estate tax purposes, only one-half of the value of such property will qualify for a stepped-up income tax basis (see earlier discussion of basis and step-up). The other half gets the decedent’s or “carryover” basis, as would be the case with a gift. See I.R.C. § 1014(b)(6).

Example: Julie and Jacob were married 45 years ago. Shortly after the wedding, they purchased a three bedroom colonial home in suburban Chicago for $23,000. Recently, Julie suffered a stroke and died. Since their two children were grown, Jacob no longer needed such a big house for just himself. So, he sold it to a young couple for $330,000. Since this home is owned by a tenancy by the entirety, only one-half of the value ($165,000) is included in Julie’s estate. Due to the unlimited marital deduction, Jacob will not have to pay estate tax on this asset. His basis in the property, however, will only receive a step up in value for Julie’s one-half interest that was included in her estate. His one-half interest will keep the original basis. So, the new blended basis of the home will be $176,500 (($23,000/2) + ($330,000/2)) instead of $330,000.

Despite this general rule, some courts have allowed a full step up in basis for spousal joint tenancy property acquired prior to 1977. See, e.g., Gallenstein v. United States, 975 F.2d 286 (6th Cir.).

Example: Julie and Jacob were married 45 years ago. Shortly after the wedding, they purchased a three bedroom colonial home in suburban Chicago for $23,000. Recently, Julie suffered a stroke and died. Since their two children were grown, Jacob no longer needed such a big house for just himself. So, he sold it to a young couple for $330,000. Since this home is owned by a tenancy by the entirety, only one-half of the value ($165,000) is included in Julie’s estate. Due to the unlimited marital deduction, Jacob will not have to pay estate tax on this asset. Since Jacob lives in a state (Michigan) where its courts are bound by the Gallenstein decision in the 6th circuit, which recognizes a full step up in basis for spousal joint tenancy property acquired before 1977, his new basis in the property will be $330,000 instead of $23,000 or $176,500.

Miscellaneous property

Other items that an estate can contain are cars, boats, furnishings, artwork and annuities. In addition, depending on the decedent’s previous profession, the estate could contain royalties, residuals or business interests, to name a few. All these items are also included in the gross estate.

Despite these all encompassing inclusions, there are reductions available, tailored to various groups of taxpayers. For artists whose estate may contain artwork they created, there is the possibility of a discount. For owners of family businesses, there is a limited deduction for passing a “qualified family-owned business interest” to a “qualified heir.” See I.R.C. §§ 2032A. The maximum deduction for this type of transfer is $675,000 and it must be coordinated with the changing unified credit amount. See I.R.C. §§ 2057(a)(2), (a)(3). Also, it has been eliminated for decedents dying after December, 31, 2003. See I.R.C. § 2057(j).

It is not unusual for the tax code to reflect current events. Specifically, after the September 11, 2001 terrorist attack, a new section was added to modify the tax rate charged on the estates of those who were victims of this attack (retroactively, victims of the 1995 Oklahoma City bombing were also included). See I.R.C. § 2201(b)(2). In addition, the reduced rates apply to decedents who were killed while serving in a combat zone. See I.R.C. § 2201(b)(1). In order to take advantage of these reduced rates, the executor of the estate (the person in charge of handling the estate’s matters) would have to make an election on the return. See I.R.C. § 2201(a).

Example: In 2001, Veronica died in the terrorist attack on the World Trade Center. Her will left a bequest of $161,000 to her daughter, Olive. Assuming the entire amount was subject to estate tax, $42,320 estate tax would be due. However, due to the special circumstances surrounding Veronica’s death, her executor could elect for her estate to pay a lower rate under I.R.C. § 2201. Using the rate table in subsection (c) of that statute, the estate tax on the same $161,000 would only be $720.

Transfers during decedent’s lifetime (within three years of death)

Pursuant to I.R.C. § 2035(a)(2), if, within three years of death, a donor transfers one of the following interests, its value at the date of death is included in the decedent’s estate:

  • life insurance policies;
  • retained life estates;
  • a transfer where the decedent continued to posses the life estate, interest or power until death.
  • certain other retained interests

See I.R.C. §§ 2042, 2036, 2037, 2038, respectively. See, e.g., Estate of Maxwell v. Commissioner, 3 F.3d 591 (2d Cir. 1993) (retained life estate). Despite the various labels, just remember that if the decedent was able to retain some type of enjoyment of the asset or power over its administration, its value would probably have to be included in the estate.

Example: Charlie was a very wealthy real estate developer who lived in Kansas. To complement his risk taking in the business world, he also participated in a number of daredevil sports, such as skydiving. In addition, he was a very generous man, so he often gave away huge gifts to family and friends. One of his possessions was an old life insurance policy with a death benefit amount of $2,000,000. Since he owned other policies on his life, in 2002, he transferred ownership in that policy to his former college roommate, Andrew, who was also his business partner in several real estate deals. In April of 2003, Charlie died while participating in an amateur racing event. Since Charlie had transferred ownership of the $2,000,000 to Andrew within three years of his death, the proceeds of the policy are included in Charlie’s gross estate for federal estate tax purposes.

Furthermore, the total value of gift taxes paid by the decedent or by his estate on gifts made by the decedent or his spouse, within three years of death, is included in the gross estate. See I.R.C. § 2035(b).

Powers of appointment

The gross estate includes the value of any property over which the decedent held a “general power of appointment” at the time of death. See I.R.C. § 2041. An individual holds a general power of appointment where he has the power to appoint to himself, his estate, his creditors or the creditors of his estate the right to own or enjoy property at present or in the future. See I.R.C. § 2041(b)(1). This is true even though the decedent did not actually have the money at the time of his death. There are three major exceptions to the general rule of inclusion.

One exception is if the power “is limited by an ‘ascertainable standard’ relating to the health, education, support or maintenance of the decedent,” the property subject to the power will not be included in the gross estate. See I.R.C. § 2041(b)(1)(A). In other words, if the holder of the power can only use the money for the certain limited purposes described above, then the power will not be considered a general power of appointment. But, if there is too much ambiguity as to how much can be distributed, the person exercising the power is deemed to have enough discretion to maintain control over the property (the holder has too much power over the disposition of the money), then the property will be included in the estate.

Example: Jerry had established a trust for the benefit of his daughter, Elaine, and had named himself as a trustee. The trust called for Elaine to receive 80% of the income of the trust on a yearly basis. The trust permitted the trustees to increase the percentage of income payable to Elaine beyond the prescribed 80% when, in their opinion, such an increase was needed in case Elaine got sick or when such an increase was desirable in view of the circumstances. In addition, the trustees were given the discretion to cease paying income to Elaine altogether. Another article gave broad administrative and management powers to the trustees. Here, since Jerry retained the unrestricted power to distribute the trust income (equivalent to retaining some of the incidents of ownership), the value of the trust is included in Jerry’s estate. See Old Colony Trust Co. v. United States, 423 F2d 601 (1st Cir. 1970).

Computation of estate tax

There are five principal steps in determining the federal estate tax liability:

  1. Determine the gross estate under I.R.C. §§ 2031 through 2046 (the rules for which has been subject of this subchapter).
  2. Subtract from the gross estate the deductions permitted under I.R.C. §§ 2051 to 2056 to determine the taxable estate.
  3. Determine the adjusted taxable gifts made during the decedent’s lifetime and add them to the taxable estate.
  4. Apply the estate tax rates, found in I.R.C. § 2001, to the sum in Step 3 to determine a tentative tax.
  5. Subtract the unified credit allowed by the I.R.C. from the figure in Step 4 to determine the actual federal estate tax.

The federal estate and gift tax law provides a single unified rate schedule for both estate and gift taxes. See I.R.C. § 2001. This section breaks down the amounts that are required to be paid based on the amount of money in the taxable estate. Chart V is an excerpt from the rate chart listed in I.R.C. § 2001, as an aid in calculating the tax for an estate.

Example: Greta died in 2003. Her estate contained the following items:

Cash, stocks, bonds $2,300,000
Personal Residence $1,750,000
Vacation home $ 550,000
Furnishings/artwork $1,850,000
Total gross estate: $6,450,000

In addition, expenses of the estate were $220,000 and she left a $1,000,000 bequest to a charity.

Computation:

Total gross estate $6,450,000
Less: deductions (1,220,000) ($220,000 expenses; $1 m to charity)
Taxable estate $5,230,000

Tentative tax $2,363,500
Less: unified credit ( 345,800)
Net tax liability $2,017,700

Unlike for gifts, which are tax exclusive, testamentary transfers are usually tax inclusive (as discussed earlier), which means any applicable estate tax, is proportionately allocated to each asset such that the beneficiary actually pays the estate tax. This is known as tax apportionment. Accordingly, the net value of the asset received will be less. However, if an asset is exempt from the estate tax (such as a charitable bequest), that bequest does not have to contribute toward paying the estate tax bill.

Example: The $2,017,700 net tax liability would be allocated to Greta’s assets as follows:

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