Estate Tax, Gift Tax, and Generation-Skipping Transfers
By Cowles Liipfert
Estate Tax, Gift Tax and Generation-Skipping Transfer (GST) Tax have nothing to do with income tax. The recipient of a gift or inherited property does not owe income tax on the gift or inheritance. Gift taxes, if any, are the primary responsibility of the donor. Those taxes are totally separate and apart from income tax. One income tax-related point, however, is that the recipient of property which has appreciated in value since acquired by the donor, takes the donor’s cost basis for income tax purposes, instead of the value of the gifted property on the date of the gift, and if the recipient sells the property at a higher value than the donor’s cost basis, there will be capital gains tax upon the sale. When appreciated property is transferred at death, instead of by lifetime gift, the recipient’s cost basis is stepped-up to the date-of-death value.
The modern estate tax was enacted in 1916. It is a tax on the transfer of assets of substantial value by a deceased person to others. The tax applies to property transferred by will or to transfers at death under state law, such as the North Carolina Intestate Succession Act. It also applies to property transferred by beneficiary designation, such as retirement accounts and life insurance proceeds on policies owned by a decedent, as well as property owned jointly with right of survivorship, payable-on-death or transfer-on-death accounts, etc., at least to the extent to which the decedent contributed to joint accounts, and transfers passing at death under revocable trust agreements.
Proponents of estate taxes consider it to be a progressive, fair source of government funding, and a good way to break up large accumulations of wealth in wealthy families. Winston Churchill once described estate taxes as “a certain corrective against the development of a class of the idle rich.”
Not too long after the adoption of the estate tax laws, people started giving away assets during their lifetimes, often on their deathbeds, to avoid estate tax at death, as a result of which, federal gift tax laws were adopted several years later, covering lifetime gifts.
To encourage some lifetime gifts in limited amounts, the gift tax laws give some “wiggle room” in allowing gifts without gift tax ramifications. Gifts which are currently exempt from gift tax include: gifts from a donor to an individual recipient which do not exceed a total value of $15,000 in a calendar year, gifts to spouses who are US citizens, and gifts for tuition as an educational expense and certain medical expenses. But please note that educational and medical gifts may not be given to an individual who uses the money to pay those expenses. Instead they must be paid directly to the educational institution or medical provider. Medical insurance premiums qualify for the medical exception, if paid directly to the insurer. Tuition and medical gifts are described in more detail under another article.
After the onset of gift taxes, creative tax planners came up with other devices to avoid estate and gift taxes on the transfer of wealth from one generation to another: Gifts could be made directly to grandchildren, for example, instead of to children, which would eventually skip a generation for gift or estate tax purposes. Also, taxable gifts could be made to trusts, instead of individuals. The trusts would have beneficiaries of multiple generations, and would not become part of the taxable estates of one or more generations of beneficiaries to receive benefits from the trusts. The trusts could make distributions to beneficiaries of one generation, without the value of the trust’s assets being subject to estate tax for a beneficiary at the time of his or her death. The trusts could simply “hang out there,” not belonging to any beneficiary for estate tax purposes, for multiple generations, without being subject to estate tax at the death of any beneficiary. Under the terms of the trust agreements, distributions could be made in the trustee’s discretion to beneficiaries from any generation, but without the principal value of the trust ever becoming part of a beneficiary’s taxable estate.
To limit that from being abused, a “generation-skipping” transfer tax was adopted in 1976. There could be perfectly good non-tax reasons for some “generation-skipping” gifts, such as the protection of assets for grandchildren if their parent had financial or other personal problems. Consequently, generation-skipping gifts were not abolished for tax reasons, but they were limited instead.
The generation-skipping transfer tax laws are very complicated and are commonly used only by very wealthy families, so we will not discuss those laws in detail here, but we will focus on gift tax and estate tax laws and their unified tax system. We recommend that anyone who is interested in generation-skipping transfer tax planning should discuss the same with one or more qualified professionals.
Federal Estate Tax
The federal estate tax applies to the transfer of property from US citizens or residents at death. Under the Tax Cuts and Jobs Act effective in 2018, the estate tax exemption is now $11.4 million (in 2019) for single persons, and with effective tax planning, $22.8 million for married couples. That Act is currently scheduled to be effective only through 2025, during which time the exemption will be indexed annually for inflation. Taxes on assets in excess of the exemption are taxed at a 40% rate. However, if a decedent is married, he or she may leave unlimited assets in excess of that value to his or her spouse, either outright, in a “marital trust” or in a “Qualified Domestic Trust” (QDOT) for non-citizen spouses, free of estate taxes at the first spouse’s death, but which will later be taxable as part of the surviving spouse’s estate. For a marital trust or a QDOT to qualify for the estate tax marital deduction, certain rules must be followed. We have a separate article discussing QDOT trusts for noncitizen spouses.
The tax basis (for capital gains tax purposes) is stepped up to the date-of-death value, which means that any unrealized capital gains on that date are never subject to capital gains tax. Journalist Michael Kinsley called this the “angel of death loophole.”
The estates of both US citizens and US residents are subject to estate tax.
Please be aware that different rules apply to estate taxes where one spouse is a non-citizen of the United States, even if the non-citizen spouse has been a resident of the United States for many years. Transfers to a non-citizen spouse do not qualify for the estate tax marital deduction unless they are left to a QDOT trust, and a certain election is made on a timely-filed estate tax return. But if the spouse becomes a US citizen before the filing deadline for the estate tax return, those transfers would qualify for the deduction without a QDOT.
Also be aware that estates of non-citizens who are nonresidents of the United States (“nonresident aliens”) and who own certain assets located in the United States, are required to file estate tax returns (on Forms 706-NA) for those “US-situated” assets, if those assets exceed $60,000 in value. That is, the applicable exemption for nonresident aliens on those assets is only $60,000, in stark contrast with an exemption of $11.4 million in 2019 for US citizens or residents.
Federal Gift Tax
Congress enacted the federal gift tax to prevent US citizens and residents from avoiding estate tax by transferring their wealth before they die.
The federal gift tax laws currently allow an amount each year that may be disregarded for both gift (and later estate) tax purposes, called the “annual exclusion.” The current exclusion in 2019 is $15,000 per year for total gifts to a recipient made during the year, applicable to “present interest” gifts. That is, a gift which is to take effect in the future, instead of immediately, does not qualify for the annual exclusion. The annual exclusion is granted to a donor separately for each recipient. A married couple would each have annual exclusions, so the couple could collectively give $30,000 in 2019 to a recipient, and the collective gifts could be made either from their separate assets or from the assets of both spouses, to each recipient.
The gift tax laws also provide a lifetime exemption for taxable gifts made by US citizens and residents (currently $11.4 million per donor in 2019), which is the same amount as the federal estate tax exemption, and the gift tax laws and the estate tax laws are integrated into one “unified” system, i.e. – taxable lifetime gifts reduce the exemption amount available at death on the federal estate tax return, and any taxes actually paid on lifetime gifts are credited toward the federal estate tax at death.
Gifts to spouses who are US citizens are not taxable, and there is no limit to the amount which can qualify for the gift tax marital exclusion. However, the unlimited marital exclusion does not apply for non-citizen spouses, even if they have been residents for many years. Gifts from a US citizen or resident to a non-citizen spouse are exempt up to $154,000 per year in 2019, indexed for inflation.
Another rule applicable to noncitizen spouses: If a US citizen or US resident spouse deposits money into an account in joint names with a spouse who is a US citizen, there is no gift unless the other spouse withdraws money from the account; that is, if the spouse who transferred the money into the account dies, the entire balance transferred by the decedent is treated as part of the taxable estate of the deceased spouse. However, if the account is a joint account with a noncitizen spouse with right of survivorship, then the account is generally treated as owned one-half by each spouse, meaning that a taxable gift has occurred on the creation of the account, except to the extent that money was contributed by the noncitizen spouse, and would be treated as a taxable gift, to the extent that it exceeds the annual gift tax exclusion (of $154,000 in 2019, indexed for inflation). There is a narrow exception to that rule, however, if the parties can prove that their intent was that the money was not to be withdrawn by the noncitizen spouse except for a special purpose which had not occurred.
Gifts include more than just cash transfers. Gifts of assets other than cash (e.g., stocks and bonds, mutual fund shares, partnership or LLC interests, parcels of real estate, etc.) are taxed at their fair market value on the date of the gift. The payment of rent or similar expenses for an adult recipient would be a taxable gift. If someone lends a large amount of money to someone else, either interest-free or at a very low rate of interest (the US Treasury Department publishes an official rate of interest each month, called the Applicable Federal Rate (AFR); if you charge less than the AFR for loans of totaling more than $10,000 to the borrower, the difference is deemed to be a gift).
Gift Tax Marital Deduction for Same-Sex Marriages
North Carolina denied marriage rights to same-sex couples by statute adopted in 1996. A state constitutional amendment was approved in 2012 which defined marriage between a man and a woman as the only “domestic legal union.” This amendment was approved by North Carolina voters by 61% to 39% vote.
In 1996 a federal law was adopted titled the Defense of Marriage Act (DOMA), Section 3 of which defined marriage as the legal union of one man and one woman.
Since those dates, state and federal court decisions have affected federal gift, estate and GST tax laws as they apply to same-sex marriages.
In 2013 a US Supreme Court decision recognized same-sex marriages for gift, estate and GST tax, provided that those marriages were valid under the laws of the states in which those marriages occurred, and it made no difference whether either spouse was a resident of the state in which the marriage occurred. It also makes no difference whether same-sex marriages are recognized in the state of residence of the married couples.
In Notice 2017-15, the IRS described the procedures which same-sex couples may use to re-calculate the marital exclusion amounts for property transferred to spouses before the US Supreme Court invalidated Section 3 of DOMA in 2013, if the gifts did not qualify for the marital deduction for federal gift, estate or GST tax purposes, solely because of DOMA.
If the applicable limitations period has not expired, a taxpayer may file an amended gift tax return or a supplemental estate tax return, on which he or she may claim a refund for taxes which have been paid, as well as restoration of the taxpayer’s applicable exclusion amount.
After the limitation period has expired, no refund can be claimed, but Notice 2017-15 allows the taxpayer to recalculate his or her applicable exclusion amount as a result of recognizing the marriage, and may recalculate the taxpayer’s remaining applicable exclusion amount as directed by the IRS in its forms and instructions.
Many of the issues have been resolved in a taxpayer-friendly way.
This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified tax professional.