National Paralegal College

Federal Transfer Taxes – An Overview

by Stephen Haas

Introduction

Although individuals have a right to transfer their property after death, this transfer might also be subject to taxation. An estate tax is levied on the transfer of property at death and is based on the size of the estate. An inheritance tax is levied on property received from the decedent and is based on the amount received by the beneficiary. The federal government has enacted an estate tax but not an inheritance tax.

Lifetime gifts were once used as a technique to avoid a transfer tax at death. However, the Federal Gift Tax was enacted in 1924 (repealed in 1926, but reinstated in 1932), as a way to counter this trend. A gift tax is imposed on gifts made during one’s lifetime if they exceed a certain amount. The rate is progressive and cumulative over a donor’s lifetime.

Another device that was sometimes used to get around the system of transfer taxes was the creation of generation-skipping trusts. These trusts were structured to eliminate transfer tax liability for succeeding generations by giving gifts straight to one’s grandchildren. This “skipping” of the middle generation saved the transfer taxes that would have been due had the property been given to the middle generation person and then been given from the middle generation person to the grandchild. As part of the restructuring of the estate and gift taxes (creating a unified system), the Tax Reform Act of 1976 created an entirely new generation-skipping transfer or “GST” tax on these trusts to prevent tax avoidance. This was done by taxing the entire gift to the grandchild as though it had passed through the estate of the skipped generation. In other words, generation-skipping transfers were taxed as if both transfers (to the middle generation person and from the middle generation person to the grandchild) were made.

Federal Estate Tax

The federal estate tax is a tax on the transfer of property at death. The estate tax is calculated on the value of property owned or passing at death (“taxable estate”), taking into account the value of the gross estate less allowable deductions. The gross estate consists of all property of a decedent, real or personal, tangible or intangible, wherever situated. I.R.C. § 2031(a).

Every individual has a unified lifetime exemption that combines the estate and gift tax systems. As of 2014, the lifetime tax exemption amount is $5,340,000. This means that a person can die with a gross estate of up to $5,340,000 without incurring an estate tax (if he or she made no lifetime gifts). However, if the person made lifetime gifts, the amount of the lifetime gifts are applied toward the unified credit, which decreases the exemption available at death for the estate tax. Keep in mind that the exemption will increase each year to adjust for inflation. For example:

In 2014, Veronica died and left her entire net $5,340,000 estate to her daughter, Olive. Veronica made no taxable gifts during her lifetime. Since the exemption amount for decedents dying in 2014 is $5,340,000, the estate would pay no estate tax.

In contrast, for nonresidents who are not citizens of the U.S., the estate tax applies to that part of the decedent’s gross estate which is located in the United States with a minimal credit amount that is much lower than the credit allowed to citizens and residents. See I.R.C. § 2012. In addition to being taxed on much smaller estates, the procedures also differ, although the same range of tax rates apply to these nonresident aliens. See I.R.C. § 2101(b).

Rates

The minimum estate tax rate is 18% and the maximum estate tax rate is 40% of the amount in excess of the exemption. The tax is paid by the estate prior to distribution of the estate to beneficiaries, so the estate beneficiary receives the bequeathed property less the estate tax owed on it.

The Marital Deduction

Transfers from one spouse to another, if both spouses are U.S. citizens, are not subject to any estate taxation. There is an unlimited “marital deduction” for estate tax purposes.

Charitable Deduction

An unlimited deduction may be taken for the value of property (reduced by any expenses or taxes payable from such property) included in the decedent’s gross estate that is transferred in a qualifying manner for public, religious, charitable, scientific, literary or educational uses. See I.R.C. § 2055.

Expenses

In determining the taxable estate, certain expenses are permitted as deductions, including:

See I.R.C. §§ 2053(a)(1)-(a)(3), 2054, respectively.

State Transfer Taxes

Many states impose their own estate taxes on deceased citizens of their states and on people who own property within the state when they die.

Prior to 2005, the Internal Revenue Code allowed a “credit” against the federal estate tax for state death taxes, but only up to certain limits. Because of this limitation, most states simply assessed an estate tax that is equal to the maximum credit that is allowed against the federal estate tax. In other words, the federal and state systems were historically coordinated so that most states imposed their own estate tax only insofar as that amount could be deducted from federal estate tax liability, resulting in no additional tax being paid as a result of the state estate tax.

However, in 2005, the credit for state estate taxes was eliminated and replaced by a deduction for state estate tax paid. Some states reacted to this by eliminating their estate tax all together (e.g., Texas, Florida and Ohio). Other states continue to impose an estate tax, with exemption amounts ranging from $675,000 to $2,000,000 or more. The rates in virtually all cases remain in accordance with the former federal rules for the state death tax credit.

For example, New Jersey’s estate tax has an exemption of $675,000. Accordingly, New Jersey estates of more than $675,000 will incur estate taxes even though they may not be subject to the federal estate tax.

Federal Gift Tax

The gift tax is imposed only on completed gratuitous transfers or transfers not made for adequate and full consideration, in money or money’s worth. The tax is imposed whether the transfer is to as a person or a trust, whether the gift is direct or indirect and whether the property transferred is real or personal, tangible or intangible. See I.R.C. §§ 2501(a)(1), 2511. The maximum tax rate is 40%.

In order to qualify as a gift, the donor must give up “dominion and control” of the property, thereby retaining no power to change its disposition. See Treas. Reg. § 25.2511-2(b). The donee receives the property unreduced by the gift tax, which is paid by the donor.

To calculate taxable gifts, the total exclusions and deductions are subtracted from the total amount of the gifts given in a calendar year.

Exclusions

For many years, the first $10,000 of a present interest in property transferred to a donee during the calendar year was excluded. See I.R.C. § 2503(b). This is commonly known as the “annual exclusion.” For transfers made after 1998, the annual exclusion is indexed every year for inflation, rounded to the next lowest multiple of $1,000. See I.R.C. § 2503(b)(2). For 2014, the annual exclusion is $14,000, per donee. For example:

Jane gives gifts in 2014 of $14,000 to each of her three children, her seven grandchildren and also to the four neighbors who are especially helpful to her. She does not owe any gift tax and does not have to file a gift tax return (Form 709). However, if Jane gives $15,000 to her oldest granddaughter as a wedding gift, she will have to file a Form 709 and report $1,000 gift. She may not have to pay any gift tax, however, depending on how much of her lifetime exemption she has remaining.

A husband and wife, who are both either U.S. citizens or residents, can give up to $28,000 to the same person during a calendar year without making a taxable gift because the gift is considered to be made one-half by each. See I.R.C. § 2513. This is called gift-splitting. The election is made on a federal gift tax return for that year.

The amount of tuition paid directly to a qualifying educational organization on behalf of an individual is fully excluded from gift tax. The student can be full- or part-time. See I.R.C. §§ 170(b)(1)(A)(ii), 2503(e)(1). Any payments for items other than tuition, however, such as room and board or books, do not qualify for this exclusion.

The direct payment of expenses for medical care on behalf of an individual, to the person or organization providing medical services, is also excludable from the gift tax. Typically, these expenses would encompass payment for doctors, hospitals, medical transportation and prescription drugs. See I.R.C. §§ 213(d), 2503(e)(2)(B).

Marital deduction

Pursuant to the Economic Recovery Tax Act of 1981, gifts made after 1981 between spouses who are U.S. citizens, are eligible for an unlimited marital deduction. See I.R.C. § 2523(a). For spouses who are not U.S. citizens, only a limited amount ($145,000 as of 2014) of the transfer amount qualifies for the gift tax marital exclusion. The remaining balance would be considered a taxable gift and taxed the same way as other taxable gifts.

Charitable deduction

An unlimited deduction is allowed for the value of property given for public, charitable and religious uses. See I.R.C. § 2522.

Federal Generation-Skipping Transfer Tax

The generation skipping transfer (“GST”) tax is a separate tax imposed on transfers to “skip” people. Broadly, these are defined as people who are:

(1) grandchildren or others more than two generations below the grantors, if this gift is to a lineal descendent or close relative (a great nephew, for example, is also a “skip” person); or

(2) non-related persons who are more than 37 ½ years younger than the grantor.

The tax is imposed on both lifetime gifts and posthumous transfers.

This tax is imposed at the highest marginal rate of gift and estate tax (40% in 2014). See I.R.C. §§ 2601, 2613. There is a lifetime exemption of $5,340,000 (for 2014, indexed for inflation) against transfers subject to the GST tax.

The purpose of the GST tax is to prevent people from avoiding estate and gift taxes by transferring assets to their grandchildren instead of their children, and thus avoiding the double tax liability that would have occurred had there been two transfers instead of one (one from parent to child and a second from child to grandchild). To circumvent this strategy, the government simply adds the GST tax to the regular estate tax (or gift tax) so that the government will get their double taxation in any case.

Exclusions

Just as with the gift tax, annual exclusion gifts and direct payments for educational and/or medical expenses are not subject to the GST tax. However, special provisions are required to qualify gifts in trust for the GST annual exclusion. See I.R.C. § 2642(c)(2).

There is also an annual exclusion for the GST tax just as there is for the gift tax ($14,000 in 2014).

Direct and Indirect Skips

Sometimes a gift or bequest to a “skip” person may not vest immediately in that person. For example, a gift could be to a trust from which the grandchild may potentially receive assets, but which gifts are not guaranteed to eventually go to the skip person. In such a case, the taxpayer (or his or her executor if after death) may have the choice as to whether to allocate some of the taxpayer’s GST exemption (the $5,340,000) to the gift made to that trust. This is called an “indirect” skip (as opposed to a transfer directly to a skip person, which is a “direct” skip).

If the exemption is not allocated to that transfer and money is later paid from the trust to a skip person, this money may be subject to GST tax. Whether and when to allocate available GST exemption to a specific transfer is a complex decision that depends on many factors and should only be made by an expert in transfer tax law.

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National Juris University, the graduate division of National Paralegal College, offers the following programs:

Master of Science in Legal Studies
Master of Science in Compliance Law
Master of Science in Taxation