Annual Gift Tax Exclusion Amount for 2013

"Gift" is the painting's title

For the past couple of years the annual gift tax exclusion amount was $13,000. This meant that a person could gift up to $13,000 to another person without (a) having to file a gift tax return and utilizing a portion of their lifetime gift tax exemption amount or (b) filing a gift tax return and paying the gift tax in order to avoid a loss of a portion of their lifetime gift tax exemption amount. Of note, the gift tax applies to any type of property transfer, personal, real, intangible, etc. IRC §2511(a) Thus, the transfer of stock, a home or a musical copyright would count as a gift if certain conditions were met.

In October, the IRS announced that the annual gift tax exclusion amount for 2013 would be $14,000. The reason for the increase is to reflect inflation. In prior years, inflation did not merit an increase in the exclusion amount.

There is no California gift tax. Hence, the increase only affects the federal gift tax.

It should be noted that certain items are not subject to gift tax regardless of the size of the gift. For example, gifts made to charity, payment of medical expenses, payment of school tuition and intra-spousal gifts are all considered exempt from the gift tax. This means that a person could pay the entire tuition costs for a student attending McGeorge School of Law for Spring 2013, $21,486, and not have to worry about any gift tax liability or ramifications. I use McGeorge as a reference because I went to school there.

As of this writing, there has been no legislation affecting the estate and gift tax regime for 2013. For both of these items, the exclusion amount for 2012 is $5.12M. If no legislation is passed, the estate and gift tax will revert back to $1M exclusion limits for each. Still, the last time the estate and gift tax was addressed occurred in December 2010 in a lame duck session of Congress. Hence, just because it is the 11th hour, it does not mean that nothing will be enacted. 

So while the annual gift tax exclusion amount for 2013 has been addressed, the more important lifetime exclusion amounts for both gifts and estates remain a mystery. Ultimately, something will occur in the next month or so. Either the estate and gift tax will be amended to increase the lifetime exemption amount or nothing will happen and each will revert back to $1M. An optimist would say that at least some resolution will be reached shortly.

Foreign Inheritance Tax?

PD-1923

The United States, as famously stated, is a nation of immigrants. Naturally then, many U.S. persons have close relatives that reside abroad. For example, I have many close relatives living in Iran, namely Tehran and Shahmirzad, from my father's side of the family. Invariably, relatives residing abroad will unfortunately reach a demise at some point in time. It might then be possible for a U.S. person to be the beneficiary of that foreign relative's estate. A common question that is raised when a person inherits money from a foreign estate is, "do I have to pay taxes for inherited assets from a foreign source?"

The answer to this question is no, a U.S. person does not have tax liability in regards to assets inherited from a foreign estate. However, there are reporting requirements when certain thresholds are met. 

For example, assume John Quimby is a U.S. citizen residing in Los Altos, CA, my hometown. John has a wealthy aunt that lives in Australia and maintains citizenship there. The aunt does not have a green card or any association with the U.S. The aunt pens a will and names John the sole beneficiary of her estate, which consists solely of $101,000 in a bank account. John's aunt later passes away when she is ambushed by an angry flock of seagulls at Bell's Beach. The aunt's executor eventually wires to John the $101,000 when the estate is closed. John will not have to pay the U.S. government taxes for this inherited amount. However, John will have to file with the IRS Form 3520 because the amount received from the foreign estate exceeds $100,000.

One rationale for imposing no tax on inherited assets is that the decedent presumably already paid taxes on their estate. If the U.S. government imposed a tax on a foreign inheritance, this would arguably constitute double taxation which some find objectionable.

Another rationale for imposing no tax is that this policy facilitates the in-flow of capital to the U.S. By not imposing a tax, this encourages foreigners to name a U.S. person the beneficiary of their estate because the foreigner knows that a portion of the inheritance will not end up in the government's coffers but rather will entirely end up in the beneficiary's hands.

What is important to remember is that Form 3520 relates to an inheritance. If a U.S. person receives money as a result of investment or services, this would not be considered a gift. Rather it would be considered foreign taxable income. Regardless, it should not be difficult to distinguish between inheritance and income.

There is no California equivalent to IRS Form 3520. Thus, all that is required of a foreign estate beneficiary is to file with the IRS.

Finally, if you receive an email from a supposed Nigerian prince informing you that you are the beneficiary of an astronomical amount of money, it might just be a scam. Call me crazy.

Estate and Gift Tax: Clawback

The future of the estate and gift tax is muddled to put it mildly. If no legislation is enacted before the close of the year, the estate and gift tax exemption limits for 2013 will revert back to the $1M threshold. For this year, 2012, the current estate and gift tax limit is $5.12M. In case you are curious as to the $120,000 part of the figure, when the estate tax was modified in 2010, it set the limit at $5M for 2011 and pegged it to inflation for 2012.

The estate and gift tax system are linked together so as to prevent somebody from giving away their entire estate before they die. This is known as the unified credit. If a person uses up a portion of their gift tax exemption, assuming they decline to pay the gift tax, this lowers the amount of their estate tax exemption. If a person never uses any of their lifetime gift tax exemption their full estate tax exemption remains intact.

Due to the rather large estate and gift tax exemption for 2012, $5.12M, this intrigues many an affluent parent, uncle, grandparent, etc. who wish to take advantage of the current scheme and gift a substantial amount of property to a lucky soul or souls tax-free. However, due to potential fluctuations in the estate and gift tax system, this attractive option is not as clear-cut as it appears. The following example illustrates this point.

Assume Mary Magnanimous is a wealthy widow worth $4.12M living in San Francisco, CA. She decides to gift $3.12M in cash to her neighbor James Joyce in 2012. Fast forward to January 2013 and Mary passes away with an estate worth $1M. According to the estate and gift tax regime, lifetime gifts are added to the value of a decedent's estate. This is where the term "clawback" comes from. In other words, gifts made during the decedent's life are brought back into equation when valuing the decedent's estate. The problem for 2013 is what happens to a person like Mary Magnanimous who decides to gift an amount in excess of $1M, will the gift be subject to clawback or is the gift not subject to clawback? In other words, when Mary passes away in 2013, will her estate be valued at $1M or will it be valued at $4.12M. The former figure represents Mary's estate value excluding her $3.12M gift in 2012 whereas the latter represents Mary's estate value including her $3.12M gift in 2012.

The application or non-application of clawback is enormous. If clawback is applied, her estate would be subject to a 35% estate tax on the amount above $1M, namely $3.12M, which results in a tax of $1.092M owed to everybody's friend, the IRS. Conversely, if clawback is not applied,  Mary's estate tax would be $0 because her estate of $1M would not exceed the exemption amount, $1M.    

Unfortunately, there is no definitive answer as to whether clawback will occur or not. I have read online that clawback will occur automatically. This is simply not true. Don't believe everything you read on the Internet! More importantly though, the current law does not directly address the clawback issue. 

We just have to wait and see what happens to the estate and gift tax system for 2013. The very likely scenario is that a lame-duck session of Congress will take up the issue in December. That is what happened in 2010 when the estate and gift tax was set to revert back to $1M in 2011 as well.

Donate Your House to Charity

Sometimes in life you cannot have your cake and it too. 

The following case addressed a family's attempt to donate their home to a local fire department and the accompanying tax consequences.

Rolfs v Commissioner (7th Cir 2012) 668 F3d 888

The Rolfs purchased a lakefront property on Pine Lake in Chenequa, Wisconsin. The Rolfs were dissatisfied with the existing home and decided to donate the home to the local fire department for training. The fire department, not surprisingly, burned down the house in a subsequent exercise. The Rolfs then claimed a $76,000 charitable deduction on their 1998 tax return for the donated home. Their theory was as follows "[t]he taxpayers argued that the "before-and-after" method should be applied. Their appraiser started with an estimated value of $675,000 for the land and house together, based on comparisons to recent sales of similar properties in the area. Using the same method, he estimated a value of $599,000 for the land alone, without any house on it. He subtracted the latter from the former to estimate $76,000 as the value of the house alone." 

The IRS was dissuaded with this claim and rejected it. The Rolfs then lost on appeal to the Tax Court and appealed again to the circuit court of appeals.

The appellate court affirmed, finding that when donated property is subject to a condition, the condition needs to be accounted for when making the property valuation. In other words, if a donation has strings attached, you need to factor the strings into the valuation equation. In this case, a donated home, given on the condition of subsequent incineration, has practically no value. Trust me on this one.

Furthermore, the appellate court affirmed the finding that the Rolfs received a benefit of $10,000 by donating their home to the fire department. Since the old home would invariably be razed to make way for the new home, this donation essentially benefited the Rolfs aside from the charitable deduction because the fire department performed the necessary destruction of the home. Thus, if the Rolfs' deduction was upheld, the benefit to them would be twofold. First, they would receive a charitable deduction for their donated home. Second, they would avoid having to pay somebody to tear down their home. 

On the bright side, the donation saved the Rolfs the trouble of finding a company to apply a wrecking ball to their home. Hence the latter benefit remained intact despite the court's ruling, the home destruction by the fire department, while the former benefit, the charitable deduction, was disallowed.

Trust Taxation

Trusts, like any other entity, must pay income taxes for the revenue it generates during the year. One key distinction between trusts and other taxpayers is the fact that trust tax brackets are very compressed. The following graphs illustrates such as it depicts the trust tax brackets for 2010: 

Federal

              

Taxable Income	Tax Rate
$0 - $2300	15%
$2300 - $5350	$345 plus 25% of amount over $2300
$5350 - $8200	$1107.50 plus 28% of amount over $5350
$8200 - $11,200	$1905.50 plus 33% of amount over $8200
over $11,200	$2895.50 plus 35% of amount over $11,200

California

Taxable Income	Tax Rate
$0 to $7124	1.25 %
$7124 to $16,890	$89.05 plus 2.25 % of amount over $7124
$16,890 to $26,657	$308.79 plus 4.25 % of amount over $16,890
$26,657 to $37,005	$723.89 plus 6.25 % of amount over $26,657
$37,005 to $46,766	$1370.64 plus 8.25 % of amount over $37,005
over $46,766	$2175.92 plus 9.55 % of amount over $46,766

It should be noted that federal and California trust taxation varies each year so by no means do the above two graphs represent the 2011 trust tax brackets. Instead, the graphs represent how quickly a trust reaches the top income tax bracket. For example, a person in 2010 does not reach the top income tax bracket until they earn $373,650. Whereas, a trust reaches the top income tax bracket by earning a mere $11,200. Clearly this is a large discrepancy. 

Estate Tax in 2012

Since the end of the year is very much upon us, this brings changes to tax law. In particular, the Estate Tax is set to be changed, albeit ever so slightly, in 2012.

1. What will be the federal Estate Tax limit in 2012?

The federal Estate Tax limit in 2012 will be $5,120,000. This was announced by the IRS on October 20, 2011.

2. What was the federal Estate Tax limit in 2011?

The federal Estate Tax limit was $5,000,000 in 2011. When the prior Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the exemption amount was increased to $5M in 2011 and would be indexed for inflation in 2012. The $120,000 increase for 2012 reflects that.

3. What about the California Estate tax in 2012?

There is no California Estate Tax in 2012 for people who pass away after December 31, 2004.

The topic of the California Estate Tax is very popular apparently. It was easily the most commonly used keyword to reach my blog in 2011. For instance, "California estate tax 2011" was used 1,495 times to  reach my blog and "California inheritance tax 2011" was used 767 times to reach my blog.

4. What does the Estate Tax limit mean?

The figures just mentioned represent the threshold amount before tax is owed. For example, if a person passes away with an estate worth $300,000 in 2012, then no Estate Tax is due. However, if the person is worth $100M when they pass away in 2012, then it is likely that the estate will have to pay the Estate Tax. It is not a certainty however that a very affluent individual will be liable for the Estate Tax as there are deductions a person may make to avoid the Estate Tax. For example, it is quite common for the rich (or 1% for you Occupy Wall Street sympathizers) to leave a sizable portion of their estate to charity which thereby avoids the Estate Tax if the donation is large enough. IRC §2055(a).

5. Which year's Estate Tax law applies to a particular estate?

The laws in effect when a person passes away is the applicable law. For example, if a person passes away in 2011, the the limit is $5M, if a person passes away in 2012, then the limit is $5,120,000.

I have been asked on multiple occasions whether or not the year in which the trust or will was written dictates which Estate Tax law applies. No, it does not. Although it is easy to see why a person would want such a scenario. If the Estate Tax was changed, hypothetically-speaking, to a $3M exemption for 2013, people would obviously prefer to have either the 2011 or 2012 law apply because of the greater exemption limit.

Conversely, if you are inclined to leave the IRS your money, despite the inapplicability of the Estate Tax, you may due so by sending a check to the following address:

Attn Dept G
Bureau of the Public Debt
P. O. Box 2188
Parkersburg, WV 26106-2188

6. What does the future hold for the Estate Tax?

The current Estate Tax system is set to expire in 2013 and the exemption amount will revert back to $1M then. Consequently, the next election in November 2012 will greatly impact the specifics of the Estate Tax. Democrats are inclined to lower the Estate Tax limit and Republicans are inclined to increase or possibly abolish it. Thus, the victor in 2012's elections will have the opportunity to craft future Estate Tax legislation.   

Charitable Deduction - Estate Tax

Americans in general are a charitable lot. Millions of Americans annually donate to community, religious, civic and athletic organizations that operate as charitable organizations. There is an immediate tax benefit to this, the charitable deduction the donor can take on their annual tax return during one's lifetime. Conversely, even at one’s passing, there is a tax benefit to donating to charity, namely a deduction on their estate tax. The following are some questions that provide a broad overview of the topic.

1. What is the charitable deduction in the context of the estate tax?

Federal law allows a U.S. citizen or resident of the United State to leave some or all of their estate to a qualified charitable organization which will reduce their estate tax liability. IRC §2055(a).

For example Danny Decedent was a resident of Campbell, CA. At the time of his passing in 2011, Danny had earned a vast fortune because he was an early investor in Google, namely $12M. Danny was concerned about paying Uncle Sam millions of dollars in estate taxes at his death, as the tax rate for estates larger than $5M was 35%. IRC §2010(c). Danny had engaged in philanthropic endeavors during his life and wanted to benefit these charities rather than have his money be sent to Washington D.C. Therefore, Danny decided to leave his entire estate to two California-based charities, HealthCare Volunteer and CACS Government Research, via his will.

Editor’s Note: The person is fictionialized while the charities are authentic.

2. What types of charities are eligible beneficiaries?

Federal law says the following charities are eligible: (1) The United States, any state, any political subdivision thereof, or the District of Columbia, but only if the contribution is used for exclusively public purposes, (2) IRC §501(c)(3) organizations established in nonprofit corporation form, (3) IRC §501(c)(3) organizations established in charitable trust form, (4) various veterans' organizations or (5) employee stock ownership plans subject to certain conditions. IRC §2055(a).

(2) and (3) are the most common beneficiaries for reference. For example, thousands of people have left money to their university or graduate school which falls under the category of (2) and (3).

3. What happens if a donor receives something in return for the donation?

When a donor receives something in exchange for their donation, a quid pro quo basically, the value of the goods or services generally offsets the value of the contribution for tax purposes. Treas Reg §1.170A. For instance, assume a late donor gives $100,000 to their beloved alma mater, San Diego State University for example, and SDSU replies by giving the late donor’s grand niece an athletic scholarship worth $40,000. Generally speaking, the donor’s estate could only claim a $60,000 charitable deduction on the estate tax return. (IRS Form 706 for those curious).

4. Is there a limit on the charitable deduction for estate tax purposes?

Federal law does not limit the estate tax charitable contribution deduction that can be claimed. IRC §2055. Thus, a person is free to leave their estate to a charity to avoid paying any estate tax. For instance, noted multi-billionaire Bill Gates may leave his entire estate, something in the range of $56B, to a charitable organization to avoid the estate tax.

5. Is it common to leave an estate to charity?

From my experience, few clients leave their estate to charity. In particular, the select few who do leave money to charity usually allocate a small fraction of their estate to charity rather than their entire estate. Individuals who leave vast amounts to charities are often the very wealthy who face an estate tax issue. This should by no means dissuade anybody from thinking about giving to charity. It is just that many parents have a sense of obligation to provide for their children. In contrast, the very wealthy do not really have that concern because their children are taken care of already. Hence, the former often leaves their estate to their spouse and children whereas the latter leaves it charity typically.

6. Are there trusts for this?

Yes, there are trusts specifically designed to achieve a charitable estate tax deduction. Examples of these include a charitable lead trust and a charitable remainder trust.

Gift Tax Law

In a previous post, I discussed the Estate Tax and the nuances behind it. Another one of the transfer taxes is Gift Tax. Here are some questions commonly posed in regards to Gift Tax. 

1. What is Gift Tax 

The Gift Tax is a transfer tax imposed by law where a person, the donor, gives the recipient, the donee, an item of property free of consideration. In IRS speak, Gift Tax is imposed on lifetime transfers of property for less than adequate and full consideration in money or money's worth. IRC §§2501(a), 2512(b). For example, if I gave my 325i BMW to my cousin Bob for free, this would constitute a gift and Gift Tax would follow. 

2. What gifts are always excluded from Gift Tax? 

Contributions made for the following items, regardless of the contribution amount, are exempt from Gift Tax: medical expenses, educational expenses, charitable donations and gifts between spouses who are U.S. citizens. IRC §§2503(e); 2522(a); 2523(a). 

3. Who pays Gift Tax? 

Surprisingly the donor pays Gift Tax rather than the donee. IRC §2502(c); Treas Reg §25.2511-2(a). For instance, if Donald gave Hugo a $20,000 Rolex watch as a gift, then Donald would be liable for paying Gift Tax. 

4. What is the annual exclusion amount? 

The annual exclusion amount represents the figure at which a donor may avoid Gift Tax liability if they gift property for less than or equal to the annual exclusion amount.

In case you are wondering, the annual exclusion amount for 2011 is $13,000. IRC §2503(b). Spouses can gift up to $26,000 to one individual because California is a community property state.

The annual exclusion amount is also not cumulative. Thus, if a donor uses less than their annual exclusion amount for one year, they cannot transfer the surplus to the next.  For example, if Donald gave Hugo $10,000 in 2011, he could not give Hugo $16,000 (assuming the annual exclusion amount stays the same) in 2012. 

5. How does Gift Tax harmonize with estate planning? 

In light of the annual exclusion amount, some clients utilize Crummey Trusts for their children while other clients create irrevocable life insurance trusts (“ILITs”). 

6. What prompted Gift Tax? 

The Gift Tax was enacted by the federal government to prevent a person from giving away all of their property to avoid the Estate Tax. Since the Estate Tax is imposed only at death, a person could presumably drain their estate through gifting over time to prevent its application. Not surprisingly, the federal government closed this loophole in 1932 when it instituted Gift Tax. 

7. What is the Gift Tax rate? 

The Gift Tax rate starts at 18% and caps out at 35%. IRC §2502(a)(2). 

8. What is the legal definition of a gift? 

The following link explains this well. 

9. Is there a federal Gift Tax? 

Yes, there is a federal Gift Tax. All that is mentioned in this post relates to the federal Gift Tax. 

10. Is there a California Gift Tax? 

No, the State of California does not impose Gift Tax. The California Gift Tax was repealed by the California electorate via ballot proposition on June 8, 1982. Rev & T C §§13301-14302. 

11. Is inheritance considered a gift? 

Inheritance is not considered a gift in the strict legal sense. While in substance inheritance is very much like a gift in that you did nothing to earn the property, inheritance is subject to the Estate Tax not the Gift Tax. 

12. Who can I give gifts to? 

Anybody is eligible to receive a gift on your behalf. Furthermore, there is no limit on the number of donees that a donor may benefit. For example, if a donor had $130,000, he or she could gift $13,000 to ten different individuals absent Gift Tax liability. 

13. Is extending a loan to a relative a gift? 

Yes, provided you extend to the borrower-relative a below market interest rate. Federal law stipulates the minimum interest rates that must be used between a lender (you) and a borrower (relative) and lays out the income and Gift Tax consequences if the loan incorporates an interest rate below the required minimum rate of interest. IRC §7872. 

14. Can I gift services? 

No, Gift Tax applies to the transfer of property, not to services. 

15. How do you value gifts? 

A gift is valued at its “fair market value” as of the date of the gift. IRC §2512(a). Fair market value is defined as "the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts." Treas Reg §25.2512-1. 

Estate Tax in 2011

The estate tax might be the most discussed issue in estate planning but most certainly not the most relevant given the circumstances of most individuals. For example, almost invariably the first question I am asked by clients at our initial meeting is whether the government will inherit their entire estate or impose substantial taxes on it. Almost always, my response is “no.”

Regardless, the following are some common questions that deal with the nuances of the estate tax. 

1. What is the federal estate tax? 

The federal estate tax is a tax levied against a decedent's taxable estate by the IRS when the estate is in excess of a fixed amount. This fixed amount is known as the applicable exclusion or exemption amount. 

2. How is taxable estate calculated? 

The taxable estate is determined by subtracting certain deductions from the decedent's gross estate. IRC §2051.

The gross estate includes all of the decedent's property, real or personal, tangible or intangible, wherever located IRC §2031(a). For example, this figure includes homes in the U.S. and abroad, bank accounts, stocks, retirement accounts, mutual funds, bonds, promissory notes, copyrights, patents, yachts, jewelry, castles, planes, trains and automobiles, etc.

The deductions include items such as expenses, indebtedness and taxes. IRC §2053. The most common deduction is for the mortgage amount remaining on the decedent's home. Treas Reg §20.2053-7.

For illustrative purposes, if the decedent owned a $10,000,000 home with a mortgage balance of $3,000,000 along with a bank account worth $500,000, stocks worth $500,000, bonds worth $2,000,000 and mutual funds worth $1,000,000, then their taxable estate would equal $11,000,000. 

3. Who is affected by the estate tax? 

The estate tax is imposed on every decedent who is a citizen or resident of the United States. IRC §2001(a).

Nonresident aliens are taxed on U.S.-based property. IRC §§2101, 2103. 

4. What is the exemption amount in 2011? 

The exemption amount in 2011 is $5,000,000. 

5. What does $5,000,000 signify? 

The $5,000,000 figure signifies the maximum amount at which taxes will not be owed. For example, if a person passes away and leaves a $3,000,000 estate, then no estate tax will be due.
Conversely, if a person passes away and leaves a $6,000,000 estate, then the estate tax will be levied on $1,000,000. 

6. Does California have a state estate tax? 

For decedents who passed away after December 31, 2004, there is no California estate tax. However, for decedents who passed away earlier, there may be an estate tax due. 

7. What is the maximum estate tax rate in 2011? 

The maximum estate tax rate in 2011 will be 35%. This means that no matter how large the estate, for example $10 billion, the maximum taxation rate for such an estate will not exceed 35%. 

8. How do people plan for the estate tax? 

There are numerous planning strategies that address the challenges posed by the estate tax. The most common method to cope with the estate tax is to write an AB trust. In short, an AB trust will allow a husband and wife, who are both U.S. citizens, the opportunity to leave to their beneficiaries, tax-free, double the estate tax exclusion amount. The link will provide more detail about this. 

9. Is the estate tax relevant given the high exemption amount? 

The answer depends on who is answering the question. For the wealthy individual, the estate tax is a huge estate planning issue since taxation can consume a significant portion of their estate. However, since very few people have over $5,000,000 in assets, there is no need to be concerned with a largely irrelevant issue. Out of the millions of people who will pass away next year, maybe a few thousand or less will be affected by the estate tax. 

10. Will the estate tax ever be an issue for me? 

Since the estate tax is a controversial and fluid issue, the estate tax will continue to be relevant. For example, the chart below shows the estate tax exemption amount and rates for each year since 2001. The chart shows that the estate tax has been subject to fluctuations over the past decade.

Year                    Amount Excluded                   Maximum Tax Rate


2001                   $675,000                                  55%


2002                   $1 million                                 50%


2003                   $1 million                                 49%


2004                   $1.5 million                              48%


2005                   $1.5 million                              47%


2006                   $2 million                                 46%


2007                   $2 million                                 45%


2008                   $2 million                                 45%


2009                   $3.5 million                              45%


2010                   Repealed 0%                           (restrictions apply)


2011                   $5 million                                 35% 

11. Does a high estate tax exclusion amount render estate planning irrelevant? 

Regardless of the consequences of a high estate tax exclusion amount, there are many issues in estate planning that affect a large portion of the population. For example if a person's estate is, generally speaking, in excess of $100,000, then upon that person's passing, a probate will be needed to distribute the estate to the beneficiaries. Since probate is quite expensive and lengthy, the avoidance of it is recommended by estate planning attorneys. Thus, people write trusts to avoid probate. 

12. Are there tax laws related to the estate tax? 

Yes, there are many tax laws related to the estate tax. One important related law is the gift tax. The gift tax was enacted to prevent people from giving away, or gifting, all of their estate in order to avoid paying the estate tax. Thus, the gift tax caps the amount a person may gift to another person. The recently amended estate tax law, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, increased the amount of the lifetime gift tax exemption from $1,000,000 to $5,000,000. 

13. Why is the estate tax such a controversial issue? 

The estate tax is a controversial issue because political ideologies clash markedly. There are plenty of other arguments for and against the estate tax but here is one from each side. Progressives see the estate tax as preventing dynastic transfers of wealth that create trust fund babies who lack the necessary ambition in life to succeed. Conversely, conservatives see the estate tax, or Death Tax as they like to call it, as an unfair form of taxation because the estate has already been levied an income tax. 

14. Who benefits from the estate tax? 

Clearly the federal government benefits because the estate tax generates billions of dollars of revenue for it. Also, estate planning attorneys, financial advisors, certified public accountants and associated professionals benefit from the estate tax because the very wealthy enlist their help to cope with the estate tax. 

15. When was estate tax instituted? 

The estate tax was first enacted in 1916. Since then, it has been amended numerous times. 

16. Can the estate tax be repealed? 

Yes, like any law, the estate tax can be repealed. 

17. What happened in 2010? 

Due to partisan squabbling, Democrats and Republicans were unable to amend the estate tax for 2010, which caused a temporary repeal. I do not know of any estate planning attorney who thought this would happen. This meant that regardless of the size of the decedent’s estate, no estate tax would be due in 2010.

However, other portions of the estate tax law changed in 2010 as well, most notably the “stepped-up basis” rules. In understandable language, “stepped up basis” means that a beneficiary inherits the basis of the property at the date of death value from the decedent. IRC §1014. For example, if the decedent purchased a home for $100,000 and when they died was worth $1,000,000, the beneficiary would inherit the property for $1,000,000. Then when the beneficiary later sells that asset for $1,000,000, no taxes would be due because no capital gain would have taken place.

Consequently, the vast fortunes of people such as George Steinbrenner, the former owner of the New York Yankees, and Dan Duncan, a Texas multi-billionaire, were seemingly going to be transferred tax-free to their heirs. However, due to the estate tax law, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the heirs of these fortunes are now confronted with the option of using the estate tax rules of 2010, with its unlimited estate tax cop but limited the stepped up basis rules, or the estate tax law of 2011 with its estate tax cap of $5,000,000 but with an unlimited amount of stepped basis. 

Crummey Trust

The following are questions commonly associated with Crummey Trusts:

1. What is a Crummey Trust?

A Crummey Trust is a trust in which the beneficiary, a child for example, has the power to withdraw monetary contributions made to a trust for a short period of time, 45 days for example, such that the transfer qualifies for the annual gift exclusion. IRC §2503(b). Once the withdrawal period has expired, the contribution becomes subject to the terms of the trust.

2. What purpose does a Crummey Trust serve?

A Crummey Trust is used to obtain the annual gift tax exclusion through the medium of an irrevocable trust.

For illustrative purposes, the following hypothetical should be helpful:

Samuel is a wealthy industrialist who would like to gift money to his teen aged children Bobby and Beth. Rather than give the money to his children outright, which would be most likely considered imprudent given teenager immaturity. Samuel decides to create a Crummey Trust so that he can take advantage of the annual gift tax exclusion while simultaneously keeping the trust in control of the money. 

Samuel appoints Theo to become the trustee of his childrens' Crummey Trusts by giving him $13,000 to hold in trust for Bobby and $13,000 to hold in trust for Beth. Each year thereafter, Samuel gives Theo $13,000 for Bobby's trust and $13,000 for Beth's trust. By gifting the money through a Crummey Trust, Samuel avoids having to pay gift tax for these contributions. Also, Samuel does not have to worry about his children quickly frittering away the money because the trust will restrict when distributions are made.

3. Who is the intended beneficiary of a Crummey Trust?

A child is the intended beneficiary when making a Crummey Trust.

4. Are there ongoing requirements?

Yes, each time a person gifts money (or property) to the trust, notice needs to be given to the beneficiary informing them of their ability to withdraw all or some of the contribution from the trust within a certain number of days. There is no definitive rule on the duration of the power to withdraw, although the IRS has allowed the annual exclusion for periods as short as 15 days. See, e.g., Estate of Maria Cristofani (1991) 97 TC 74, acq 1992-1 Cum Bull 1, acq 1996-2 Cum Bull 1.

For illustrative purposes, presume that on March 1, 2010 Samuel donates $13,000 to each child's Crummey Trust. Thereafter, Theo the trustee gives notice to Bobby and Beth that they may withdraw all or some of this $13,000 from the trust within 30 days . While each child has the ability to withdraw the $13,000, it is highly unlikely that either child would do so because this will strongly discourage Samuel from ever donating money to the child's Crummey Trust. Regardless, once those 30 days have elapsed, namely come April 1, 2010, the $13,000 for each child becomes the property of each's Crummey Trust.

5. Is a Crummey Trust irrevocable?

Yes, a Crummey Trust is irrevocable. Thus, once a person creates a Crummey Trust, they cannot later on revoke it. This is particularly important, since most trusts written in California, colloquially referred to as "living trusts", can be revoked.

6. Where does the name "Crummey Trust" come from?

The term "Crummey Trust" is derived from the court case which validated its usage. Crummey v Commissioner (9th Cir 1968) 397 F2d 82.

7. How much does it cost to write a Crummey Trust?

There is no mandatory minimum or maximum attorney fee to draft a Crummey Trust.

8. In light of the attorney fee, can I write my own Crummey Trust?

Yes, California law explicitly says that you may act as your own lawyer. However, given the technicalities associated with a Crummey Trust, it is not a document that can be easily drafted by a non-attorney. Frankly, few legal documents should ever be drafted without the assistance of an attorney.

Furthermore, since a Crummey Trust involves large sums of money, it is logical to presume that a person wanting a Crummey Trust can afford the attorney fee to create a Crummey Trust. 

Trust Administration - Taxes, Uniform Prudent Investor Act & Accounting

It is not uncommon for a trust to endure for many years after the original drafter(s), the settlor(s), have passed away. This can be classified as long-term trust administration. 

For example, husband and wife draft a trust with the survivor inheriting everything. Then upon the surviving spouse’s death, the remainder of the trust estate distributes to the children in equal shares outright and free of trust, provided the children are at least 25 years old. Even though at first glance it does not appear that long-term trust administration is likely, there is the distinct possibility that it may arise. For the sake of argument, let us assume that husband and wife pass away in an auto accident, leaving Son, age 18 and Daughter, age 20. Son’s trust would require 7 years of administration while Daughter’s trust would require 5 years of administration. The following are common hurdles that would be encountered in the long-term trust administration of Son and Daughter’s trust.

1. Tax Returns

First, the trustee should file Form 56 with the IRS to notify it that a fiduciary relationship exists between the trustee and the trust. IRC §§6903, 7701(a)(6); Treas Reg §301.6903-1. Second, the trustee would need to acquire a federal identification number for the trust in order to properly file tax returns. Third, the trustee would need to annually file federal and state tax returns depending on the trust’s circumstances. In particular, a trust must file a tax return in California if either the net taxable income is over $100 or the gross income exceeds $10,000, regardless of the net taxable income. Rev & T C §18505(e)-(f); FTB Form 541. A federal return must be filed if the trust has any taxable income or gross income of $600 or more, regardless of the amount of taxable income. IRC §6012(a)(4); IRS Form 1041.

2. Investments of Trust Assets - Uniform Prudent Investor Act (UPIA)

The trustee needs to be mindful of the Uniform Prudent Investor Act (UPIA) which governs investment and management of trust assets. Probate Code §§16045-16054. The UPIA is the default rule as the trust can specify a different method in evaluating a trustee’s investment decisions. Prob C §16046(b). However, most trusts do not expand or restrict the UPIA standards. Here are some important sections from the UPIA.

First and foremost, the duty of care requires that “a trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution. Prob C §16047(a). Although, “a trustee's investment and management decisions respecting individual assets and courses of action must be evaluated not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust." Prob C §16047(b). Therefore, the fact that the trustee made 10 good and 1 bad investment choices that resulted in a positive outcome for the trust does not violate UPIA.

Furthermore, “the trustee has a duty to diversify the investments of the trust unless, under the circumstances, it is prudent not to do so.” Prob C §16048. Hence, the trustee could probably not invest all trust assets in volatile stocks like British Petroleum or Goldman Sachs.

Additionally, a trustee may delegate investment and management functions, if prudent under the circumstances, to an agent of the trustee. Prob C §16052(a). Thus, a trustee could appoint a certified financial planner to assist the trustee in making investment decisions.

Moreover, “the trustee must, within a reasonable time of accepting the trusteeship or receiving the assets, review the assets and make and implement decisions concerning the retention and disposition of assets so as to bring the trust portfolio into compliance with the purposes, terms, distribution requirements, and other circumstances of the trust.” Consequently, the trustee would need to perform an inventory of the trust and determine the future goals and needs of the trust in order to achieve the trust’s stated goals.

3. Accounting

The trustee is generally required to provide at least an annual accounting to beneficiaries for trusts created on or after June 30, 1987. See Prob C §16062. An accounting is also required when there is a change of trustee and when the trust terminates. Prob C §16062(a). The accounting must contain the information specified in Prob C §16063, which is too long to cite here (trust me). However, a beneficiary may waive in writing the right to an accounting from the trustee. See Prob C §16064(c).

What is a Gift

In the spirit of Christmas, I thought it would be appropriate to legally define a “gift.” Yes, there is a legal definition to a gift. Consequently, a gift is a transfer of property that is made voluntarily and without consideration. The following elements are necessary for a valid gift U.S. v Alcaraz-Garcia (9th Cir 1996) 79 F3d 769; 13 Witkin, Summary of California Law, Personal Property §124 (10th ed 2005)):

1. There must be an intent on the part of a donor having capacity to contract to make an unconditional gift;

2. The donor's intent must be to make a present gift of the property (if the intention is to make a future transfer, there is no gift);

3. There must be an actual or symbolic delivery of the gift, i.e., the donor must relinquish control of the property; and

4. The donee must accept the gift.

For example, if I wrapped up my favorite burgundy sweater in a box, presented it to my friend Dan on Christmas day and Dan accepted the sweater, this transaction would qualify as a “gift” in legal terms. Since there was intent on my part to gift the sweater to Dan because I wrapped it up in a package, I delivered the sweater to Dan by presenting it to him in a box and Dan accepted the gift when I presented it to him.

Living Trust Myths

These are some more fallacies I have been asked, read and heard about in regards to living trusts:

Fiction: If I set up a trust I must file a separate tax return for the trust.

Fact: Most trusts do not require the filing of a separate tax return provided the person who drafted the trust has substantial control over it. IRC §§671-679. For example, if John Smith established a trust for his own benefit, the John Smith 2009 Living Trust, he would not need to file a separate tax return for the John Smith 2009 Living Trust. Such a trust in IRS speak is known as a “grantor trust.”

Fiction: If I transfer my house into a living trust, the house will be re-assessed for property tax purposes.

Fact: California law clearly says that if a couple or single person transfers their residence into a revocable trust that they created the property is not reassessed for property tax purposes. Rev & T C §§62(d). For example, if John and Mary Smith established a trust and transferred their 650 Rosewood Court residence into the trust, the assessed value of 650 Rosewood Court would remain the same after the transfer. This is particularly important for people who purchased their homes years ago and are acutely aware of the low assessed value for property tax purposes.

Fiction: Everything I own should always be transferred into a trust.

Fact: Due to tax and administrative reasons a retirement account and life insurance policy should not be transferred into a trust typically.

Fiction: If I do not write a will or a trust, the government will inherit my property.

Fact: To quote the character Randolph Duke from the movie Trading Places, “hogwash.” The government, namely the state of California, will only inherit your property (called escheat) if you have no relative or you do have a relative but they cannot be located. For example, there would be no escheat if your had either a spouse, child, parent, grandchild, grandparent, brother, sister, uncle, aunt, nephew, niece or distant cousins (Please click on the diagram below). Consequently, the odds of a person not having any relative alive when they die is ostensibly zilch. The cases in which escheat occurs, and it is very rare, comes about because a person moved far far away from their family. Ultimately, escheat is a very narrow exception to the rule that somebody other than the government will inherit your property.

Inheritance Tax

There is a great deal of intrigue, confusion and misinformation about the Federal Estate Tax, colloquially known as the "Death Tax." This intent of this post is not to advocate for or against the Estate Tax. Rather, this post is to inform readers on the remoteness of the Estate Tax in regards to their estate.

The federal estate tax is imposed on the "taxable estate" of every decedent who is a citizen or resident of the United States. IRC §2001(a). The amount of the "taxable estate" is arrived at by subtracting allowable deductions from the gross estate. IRC §2051. The gross estate of a U.S. citizen or resident for federal estate tax purposes is broadly defined to include all of the decedent's property, real or personal, tangible or intangible, wherever situated. IRC §2031(a). Thus, the Federal Estate Tax applies to worldwide assets. The largest deductions are typically those for mortgages and other debts.

For example, John and Marie Rivera (a hypothetical couple) own a home valued at $2.5M, stocks valued at $500,000, retirement accounts worth $300,000, a savings account worth $100,000 and $100,000 in misc. assets. However, the Rivera have a $500,000 mortgage. Their taxable estate would thus be $3M (I made the math intentionally simple for illustrative purposes).

Even though the Riveras are fabulously wealthy, as they are multi-millionaires, they would not be subject to the Estate Tax if both of them died in 2009. For individuals dying in 2009, the federal estate tax applies to taxable estates of $3.5 million or more, after adjusting for lifetime taxable gifts. IRC §2010(c). According to IRS figures, the current Federal Estate Tax affects only 2 percent of American decedents.

Although the Estate Tax is set to be repealed next year, the current administration has proposed extending the $3.5 exemption. Should no action be taken, the exemption would revert back to $1M level in 2011. EGTRRA-2001 §901. Most likely the $3.5M exemption will be adopted for future years given the wranglings between the two parties.

In case you were wondering, California does not have an Estate Tax. California voters overwhelmingly approved a ballot measure that ostensibly repealed the California Estate Tax in 1982. However through various legislation the California still does exist, albeit the decedent needed to have filed a Federal Estate Tax and died within the years 1982 -2004. Yet for decedent dying after 2004, there is no California Estate Tax.