CHAPTER TWO – Federal Transfer Tax Structure

Federal tax structures:

1) Transfer taxes –

   - Estate tax (transfers at death)

   - Gift tax (transfers during lifetime)

   - Generation skipping transfer tax (GSTT)

2) Income tax –

   - Tax basis rules (§§ 1014, 1015)

   - §102 – inheritances & gifts as gross income

   - Subchapter J – trust income taxation

   - Assignment of income doctrine

Evolution of the Current Federal Estate Tax

Pre-2001 (exemption to $700,000)

Pre-2010 (2002 thru 2009, increasing exclusion, to $3.5 million)

The year 2010 – repeal (but carryover basis); 2011 back to 2001.

Cf., retention of the gift tax.

But, 2010 Tax Act - 12-17-2010 –

Estate tax restored, $5 million exclusion, including for gift tax;  $5.12 mil for 2012.

Now 2013 legislation_ Permanent fix.

Objectives in Imposing Federal Estate Tax

• Revenue – $30 Billion? What % of total federal tax revenue? Relevant?

• Consider:  Economically accrued income not previously subject to income tax, e.g., § 1014 basis step-up;  i.e., “tax justice.”

3)  Reduction of wealth concentration – is this a valid concern objective/public policy concern?

Economic Effects of the Estate Tax

Is the estate tax detrimental to small business?  See analysis, p. 8  (JEC-Republicans)

Are small businesses and family farms actually being handicapped?

What is a “small business” for this purpose?

Cf., recent argument re income tax on taxpayers above $400,000 and the impact on small businesses.

Alternatives to an Estate Tax                               p.9

Inheritance tax – imposed on the recipient; tax rate is based on the relationship to the decedent.  But, collection at source.               

Accessions tax – tax on the cumulative total of value received by a person.

Income tax - inclusion in the gross income of  a bequest (& gift) amount (i.e., repeal §102).

Net worth tax (imposed on a periodic basis) –  a property ownership tax.

Effect of Carryover Basis (vs. Estate Tax)          p.10

Estate tax:  imposed at the rate of 35% above a $5.0 million exemption equivalent amount (until the year 2013).

Carryover basis structure (2010):  Capital gains rate (then 15%) above a minimum basis step-up allowance amount; deferred income tax (& consider value of deferral).

See §1022 re carryover basis (& exceptions).

Structure of the Federal Estate Tax                  p.12

Computation:

Gross estate

Less: Deductions

Equals: Taxable estate

Less: Credits

Equals: Estate tax liability

Note similarity to the income tax structure.

Gross Estate Defined -
“economic rights”?     p.12

Gross estate inclusion (§2031):

-Probate assets – property owned directly §2033 – property where decedent has an interest.   

- tax-exempt bonds?

    - accrued rent and interest income?

    - other assets, e.g. contingent claims

-Some transfers within 3 years of death –

- including the gift tax paid - § 2035(b); a tax exclusive tax.

-Cf., income tax is imposed on a pre-tax amount.

Gross Estate Defined -
“economic rights”?     p.14

Gross estate inclusion: §§2036-2038

-Transfers with retained controls

    (1) Retained economic interests, or

    (2) Retained controls

    E.g, a revocable (“living”) trust

       - a retained income interest

       - a retained right to control distributions         

-Survivorship annuities - §2039

    applies to annuity with survivorship payment

   (cf., treatment of a single life annuity)

Gross Estate Defined -
“economic rights”?     p.15

Gross estate inclusion for:

-JTWROS property (decedent’s funds) - §2040

    Issue: Who provided the consideration?

- “Power of appointment” property - §2041

     property is subject to a decedent’s control                 but is sourced originally from another.

- Life insurance proceeds - §2042  (p. 16)

     if holding “incidents of ownership”

- Transfers from the decedent’s spouse - §2044

            (see § 2056 enabling marital deduction)

Deductions reducing the gross estate              p.17

- Expenses & debts (genuine debts?)   §2053

- Losses (e.g., casualties incurred during

administration) - §2054

- Charitable transfers – §2055 - no limit on this   deduction (including split-interest gifts)

- Spousal transfers (including QTIP trusts)  §2056

- State death taxes (not relevant in Texas);  credit (repealed) for state death taxes.  P.22.

Estate tax liability computation               p.19

§2051 – taxable estate defined.

Cumulative transfer tax base – including prior lifetime gift transfers (a unified tax base).

Credit for gift tax on prior lifetime transfers.

Less:  Other credits (i.e., unified credit & foreign tax credit;  previously for state death tax paid), p.21

Cf., federal gift tax (tax exclusive applicability)

Federal Gift Tax         p.24
40% above $5 million

§2501 – imposition of this tax on gifts- imposed on a lifetime, cumulative basis.   Still applied in 2010 when the estate tax was repealed. Why?

Certain exclusions (e.g., annual donee exclusion) & deductions are available.

& $5 million exclusion.

Smith case (p.24) – re effect of subsequent gift tax revaluations on the estate tax calculation (i.e., applicable tax rate and offset for gift tax payable);  & the legislative response - §2001(f).

Generation skipping transfer tax                p.36

Purpose of the GSTT?

Situations where GSTT is applicable – 

(1) during lifetime,  (2) at death & (3) when a later trust distribution.

A separate GSTT is imposed (in addition to other transfer taxes).

Code §§2601-2604 (expired for 2010).

Reinstated for 2011 - $5 million exempt, as indexed.

Relevance of State Property & Inheritance Laws to Estate Planning?

How define the governing state law?  Consider the Bosch case impact:  state lower court proceedings determining property facts.

When is the federal tax proceeding bound by the applicable state law? Cf., Erie v. Tompkins.

Can the IRS be bound by prior proceedings in a state probate (or other) court? If not a party?

Bosch case (p.37):  “proper regard” treatment for the related state court proceeding.

Conflict of law issues
p.42

Choices of applicable law issues arising in:

• the property transfer/probate context? 

• Federal transfer tax context (consider the Bosch case)? 

Examples: 

                Land, e.g., 2^nd home or ranch;

                Corporate stock certificate (or equivalent);

                Other intangibles

&, also, applicability in state taxation context.

Conflict of law issues, Special considerations

Note: community property issues (i.e., identifying community property, including when transported across state lines into a separate property jurisdiction).

Use planning to change the situs of property (e.g., with revocable trust ownership governed by law of other state)?

What property law treatment of U.S. Treasury bonds/notes –

    special federal property regime?

Valuation Issues 
p.43

What is an appropriate valuation approach for federal estate tax purposes?  See Reg. §20.2031-1(b) re willing buyer-willing seller valuation definition.

What assets present valuation difficulties?  How is this valuation to occur?

Consider the O’Keeffe case (p.44) & similar decisions (e.g., art, real estate and FLPs).   How does taxpayer’s counsel develop an estate tax  valuation case?

Valuation & the Impact of Built-in Tax Costs

How value corporate stock when the “inside assets” have significant embedded accrued capital gain? Note: Corporate cap gains tax at 35%.  See Dunn case (p. 56) in the 5^th Circuit, & similar decisions. 

What relevance of the expectation of a near-term sale of the assets inside the corporation?

How is stock valued by a prospective buyer in an anticipated stock purchase transaction?

Valuation of Split Interests in Property  p.60

How proceed to value a split (horizontal) interest in property?

E.g., ownership of only:

1)   a lead interest, 

• a remainder interest (after a term or after a life?), or

• a reversionary interest?

See Reg. §20.2031-7(d)(6), Table B & (d)(7), Table S; what exceptions apply to the use of these tables?

Federal Income Tax – Gifts & Bequests        p.60

Gifts & bequests are not included in gross income - §102 – even though they constitute an “accession to wealth.”

What about the “income” subsequently derived from gift/bequest property?  

See §102(b) – no exclusion is available for the income component from property received in gratuitous transfers.

Income Tax Basis Issues
p.60

Income tax basis step-up at death? See §1014 (pre and post 2010).

Connecticut National Bank case, p. 62.

Cf., the carryover basis rule applicable during 2010 (§1022), if an election out of estate tax was made. See next slide.

What about IRD?  See §1014(c) & §691 providing for GI inclusion (for a cash basis taxpayer; cf., accrual basis taxpayer).

Carryover Basis at Death
§1022 – for 2010         P.67

Applicable for 2010 if electing out of estate tax.

Recipient obtains the decedent’s basis for acquired property, except lower for lesser fair market value.

Special tax basis increases under §1022: 

1)  $1.3 million value, with increase for unused built-in losses and loss carryovers; 

2)  $3.0 mil. transfers to surviving spouse.

How allocate this stepped-up basis to the various properties?  How protect the executor in making this allocation?

Gifts & Income Tax Basis
p.70

What about transferred tax basis to a donee for intervivos gifts?  See §1015.

See §7701(a)(43) re transferred basis property – received from the donor.

§1015(d)(6) – special adjustment for that gift tax attributable to the appreciation component of gifted property.

Estate Tax Administration Issues

• Estate tax return filing requirements – responsibility of the executor.

• Audit examinations by IRS?

3)   Possible to obtain an estate or gift tax private letter ruling from IRS?

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