1.3.1 Estate Tax Overview

The estate includes all of the assets of the decedent as of the date of death. These assets often are in both the probate and non-probate estate. A probate estate may include cash, CDs, stocks, bonds, real estate and tangible personal property. Non-probate estate assets frequently includes assets held in a living trust, property held in joint tenancy, IRAs, insurance policies and other assets that pass under property law or contract.

The taxable estate is valued as of the decedent's date of death and includes the probate and non-probate estate, less costs, debts and administration expenses. Alternatively, Sec. 2032 allows the executor of a decedent's estate to elect to value the estate six months after the decedent's death. The alternate valuation date may only be used if the election would reduce the gross value of the estate and lower the applicable taxes. Sec. 2032(c)(1) and (2). If selected, the alternate valuation date must be used for the entire estate and not just a part. The estate tax is calculated on the taxable estate and is due nine months after the death of the decedent.

Qualified appraisers generally determine the value of non-publicly-traded assests. The basic valuation test is the "willing buyer - willing seller" test. Reg. 20.2031-2. Publicly traded assets, such as stocks and bonds, are valued at the mean between the high and low on the valuation date. Reg. 20.2031-2(c). Real estate, family limited partnerships, limited liability companies and other closely held business assets must be valued by qualified appraisers.

A qualified appraisal of a business may include any or all of the following factors: (1) the type of business; (2) the economic prospects for that industry; (3) the book value of the business; (4) the ability to generate both gross income and profits; (5) the goodwill or value of the ongoing business entity; (6) any sales of business interest; (7) sales of comparable businesses; and (8) other relevant economic factors. Rev. Rul. 77-287.

The valuation also may be impacted by the level of ownership. If the decedent owns a controlling interest, a premium could be attributed to that control. Reg. 20.2031-2(f). Alternatively, there could be a discount for a minority interest since the minority shareholder lacks control of the business entity. Rev. Rul. 93-12. If transfers to family members created the minority interest, there may still be a justification for minority discounts.

Discounts also have been upheld for lack of marketability. A minority interest in a family corporation, a limited partnership in a family limited partnership or a number of units in a limited liability company may not be readily saleable. Because of the disadvantage of owning an asset that may produce little or no income and may not generate any significant benefit for many years, a purchaser will naturally pay a lower price. Thus, the discount for lack of marketability may result in a significant reduction in value.

To reduce estate taxes, a farm operated by a family may take advantage of a special use valuations. IRC 2032A.

There are specific requirements to qualify for this benefit. First, the decedent must have been a U.S. resident or citizen operating a farm within the U.S. Second, the farm must be transferred to a lineal descendent or spouse who materially participates in the operation of the farm for a period of 10 years. Third, the property must be valued at 50% of the estate or more. The real property must be at least 25% of the gross estate. If the farm or ranch is not operated by the family member for a term of 10 years after the decedent's death, then some of the estate tax benefit must be recaptured. Sec. 2032A(c)(1).

Life insurance owned by the insured is includable in the taxable estate. Ownership is defined as possessing "incidents of ownership" and could include any of the following rights:

Insurance may also be includable in an estate where the insured is the trustee of the trust holding the insurance and the trust powers may be used to transfer the benefit to the insured trustee. Rev. Rul. 84-179. In addition, the transfer of an existing policy within three years of death requires inclusion of the proceeds in the estate. Sec. 2035. Another way in which insurance may be includable in the estate is if the decedent owns a business or partnership and the insurance is payable to the business or partnership. The value of the insurance may then increase the value of the business or partnership and result in taxation of the estate. Finally, life insurance payable to the estate is always includable. Reg. 20.2042-1(b).

Life insurance may be excluded from the taxable estate if purchased by and owned by an irrevocable trust. The common practice is for the trust to purchase and own the policy and for the insured to retain no "incidents of ownership" under Sec. 2042. The typical method is to use a "Crummey" power and allow children the right to withdraw up to the annual gift exclusion amount during the period for withdrawal.

Assets held by spouses as joint property are deemed to be joint property in each estate. Reg. 20.2040-1(a)(2).

In all other circumstances, the consideration-provided rules apply. Reg. 20.2040-1(a)(2). At the date of death, the decedent's percentage of consideration furnished will be the percentage of the asset includable in his or her estate.

Income and remainder interests are valued in accordance with IRS Publications 1457, 1458 and 1459. These publications use table 2000 CM to set forth methodology for determining valuation. Reg. 20.2031-7(d)(7). The methodology is applicable for life interests, term of years interests and various combinations of interests. Sec. 7520. If the decedent has created a charitable remainder trust and retained an income interest for his or her lifetime, then under Sec. 2036(a), the value of the trust is includable in the estate. However, there will be a deduction for the value of the charitable remainder interest. With a charitable lead trust created in the estate, there will be a deduction for the present value of the annuity or income interest to charity, and the remainder will be a taxable transfer.

The standard mortality tables must be used for individuals who are not terminally ill. The definition of terminally ill is a person who has a 50% or greater probability of death within the year. Reg. 25.7520-3(b)(3). Survival for 18 months or longer creates a presumption that the person was not terminally ill.

Gift tax is referred to as an "exclusive" tax, while the estate tax is an "inclusive" tax. Since the estate tax is paid from the entire estate and thus included in the estate, the effective rate for estate tax is higher than that for gift tax.

In order to discourage deathbed gifts with the payment of a large gift tax, gift tax paid within three years is added back to the gross estate. Sec. 2035(b). This "gross-up" of the gift tax produces the same result as if the amount of the gift had been included in the estate.

Several changes impact special business exemptions. In 2004, the qualified family-owned business deduction was repealed. However, the 10-year recapture period for special use valuation could apply even after repeal of the estate tax until the expiration of the 10-year period. Installment payment rules for estate taxes will be retained.

Generation-skipping transfer tax (GSTT) is generally applicable when there is a direct skip, a taxable termination or taxable distribution to a grandchild. EGTRRA 2001 simplified GSTT rules by automatically allocating a GSTT exemption to any trust created during life that is an "indirect skip." Another helpful provision in the GSTT section is an allowance for a "qualified severance" of a trust into an exempt trust and a non-exempt trust subject to GSTT. Also a "substantial compliance" exception allows Treasury to permit potential reallocations of GSTT in order to produce the lowest possible inclusion ratio.

Under prior law, when a closely-held business exceeded 35% of the decedent's adjusted gross estate, an executor generally could elect to pay estate tax in two or more installments (but no more than 10). The estate could defer payment of principal and pay only interest for the first five years, followed by up to 10 annual installments of principal and interest. A special two-percent interest rate applied to the amount of deferred estate tax attributable to the first $1 million (adjusted annually for inflation occurring after 1998) in taxable value of a closely-held business.

EGTRRA 2001 expanded the availability of the installment payment provisions by providing that an estate of a decedent with an interest in a qualifying lending and financing business is eligible for installment payment of the estate tax. The bill also increased the number of partners or shareholders in an entity eligible for installment payments of estate tax from 15 to 45.