The LAW OFFICE of CLARK A. REMINGTON

First Refinement: Gifts

The value of certain gifts must be added to the value of your property before determining whether or not you exceed the estate tax exemptions. Another way of looking at it is that the estate tax exemptions can be, in effect, reduced or used up by certain gifts. To understand how gifts come into the picture, consider that the estate tax is actually (since 1976) part of a unified estate and gift tax system. The estate tax and the gift tax are meant to cover wealth transfers in such a way that one cannot escape estate taxes by giving gifts. In order to arrive at the unified amount that forms the basis of the estate tax calculation you have to add back the value of all the gifts that you gave during your lifetime that exceeded the annual exclusion amounts that were in effect at the time of the respective gifts.

The Annual Exclusion Amount

During any year, you can give gifts up to the annual exclusion amount to any number of people without cutting into your lifetime estate tax exemption. The annual exclusion amount has varied from year to year (see table). In 2016 it is $14,000. That means that during the year 2016 you can give up to $14,000 per person to any number of people without affecting your lifetime exemption. Someone might give, say, $13,000 to each of 5 people, resulting in a total of $65,000 which falls within the annual exclusion and would thus not be added into the estate tax calculation. In effect then, gifts above the annual exclusion reduce—or use up—the federal estate tax exemption dollar for dollar.

If someone dies while domiciled in Illinois, a similar issue arises with respect to gifts and their effect on the Illinois estate tax. See Effect of Gifts on Estate Tax in Illinois. Those of us lucky enough to live in Indiana don't have to worry about this.

Second Refinement: A Bit More Detail

If you want to push a little further into the details, you would start by determining the gross estate which includes the value of your probate estate and what I have been calling your non-probate estate and, in some cases, the value of property that you do not own but over which you have certain kinds of control. From this you would subtract debts and administrative expenses of the estate. Then you would subtract amounts given by your estate to qualifying charities (the charitable deduction) and to your spouse if he or she is a U.S. citizen (the marital deduction). Then you have to add back gifts given during your lifetime that were above the annual exclusion amounts (as described above). The result of this calculation is the number that you compare with the estate tax exemption amounts. If if is less than the exemption amounts, you should not have to worry about estate taxes.

An example: You die owning a total of $2,000,000 worth of property including real estate, personal property, bank accounts, investment accounts, pension, life insurance. You have $50,000 in debts and expenses of the estate. At your death you give $100,000 to the Red Cross and $1,500,000 worth of property to your spouse who is a U.S. citizen. During your life you gave no gifts above the annual exclusion amounts except in 2007 you gave your lake house (worth $750,000, which is $738,000 above the annual exclusion amount for 2007) to your daughter. The calculation would be $2,000,000 - 50,000 - 100,000 - 1,500,000 + 738,000 = $1,088,000 which is well below the federal exemption amount of $5,430,000 and the Illinois amount of $4,000,000.

Third Refinement: More on What is Included in the Gross Estate

As a final refinement, I will expand a bit on what I said above: that the gross estate will include the value of your probate estate and what I have been calling your non-probate estate and, in some cases, the value of property that you do not own but over which you have certain kinds of control.

The probate estate consists of those assets that you own outright and that do not pass automatically by law or by contract to others upon your death.

What I have called the non-probate estate consists of property that most of us think of as ours even though, strictly speaking, it does not belong to us when we die because it passes automatically to others. Property that is held jointly with others (or in the case of married couples, property that is held in what is called a "tenancy by the entirety") will pass on your death to the surviving joint owner or owners. Some of your property (certain bank accounts, securities, investment accounts, pensions, annuities, life insurance) may be governed by contracts that provide that upon your death benefits pass directly to your designees. These amounts that find their way into the hands of others according to law or contract at your death are not part of your probate estate, but they are included in your gross estate for estate tax purposes.

Finally there is property that you don't actually own but that you nevertheless control in some way. I cannot describe here all the various ways in which the IRS can reach out to tax you in this context. What I will do is give a few examples and then suggest that if you are in doubt about whether you have made transfers that are remotely like these examples you should talk to a lawyer.

Some Examples of Property You Don't Own That Gets Taxed Anyway

Trusts

Some of your property may have been transferred to trusts (either revocable or irrevocable). Trust property is not part of your probate estate. Whether or not the value of trust property is included within your tax estate can be a complicated question. There is no doubt that a revocable trust is included within your tax estate, but whether or not property held in other kinds of trusts will be included within your tax estate is determined by the extent of control you retain over the distribution of trust assets and income.

Retained Use or Enjoyment

If during your lifetime you gave property to someone but retained the income or enjoyment of the property (or retained the right to designate who would receive the income or enjoyment), then the value of the property will be added to your tax estate. For example, a parent might give a house to a child but continue to live in it during his or her lifetime. The value of the house would be included in the tax estate. This makes sense. The arrangement is the functional equivalent of the parent passing ownership of the house to the child in a will.

Right to Alter or Revoke

If during your lifetime you gave property to someone but retained and continued to hold at the time of your death the right to alter or revoke the arrangement, the value of the property would be included in your tax estate. The revocable trust is a species of this kind of case.

Powers of Appointment

It is fairly common in wills and trusts for the testator or grantor to give someone what is called a "power of appointment." The holder of a power of appointment has the power to designate or appoint who will own or enjoy property owned by someone else. What we are trying to imagine here is that you (who are considering whether you should worry about estate taxes) hold a power of appointment over property that is owned by another. Even if you never own the property and even if you never exercise the power, if you had the power to designate who would become the owner of the property and if that power included the right to designate yourself or your estate or your creditors or the creditors of your estate, then the value of the property subject to appointment would become part of your gross estate. I am passing over certain complexities and exceptions, the discussion of which goes beyond this presentation.

Perhaps one of your parents gave you the right to the income from particular trust property for your life together with a power of appointment over the trust property at your death. If that power of appointment is broad enough to allow you to designate yourself, your estate, your creditors, or the creditors of your estate as the recipient or recipients of the property, then you have what is called a general power of appointment and the value of the property subject to the power comes into your gross estate.

Three Year Look-Back

As if things weren't complicated enough, there are certain transfers that would succeed in getting property out of your tax estate as I have described it thus far but which will be brought back into your tax estate if the transfers were made within the three years immediately preceding your death. For example, imagine that you gave your house to your child but retained the right to live in it during your lifetime. Then, say, you learned (from this webpage or from talking to a lawyer) that if you were to die with this arrangement in place the value of the house would be made part of your gross estate. Now imagine that you relinquish the right to live in the house, hoping thereby to get the value of the house out of your gross estate. This maneuver will only succeed if you survive it by three years or more. Similar attempts to transfer or relinquish rights in, for example, trusts or life insurance policies in an attempt to get their value out of your gross estate will only succeed if you survive the transfer by three years or more

In Sum

Do you need to worry about death taxes? For most people the answer is no. For a great many people the answer is a very clear and easy no. But estate and gift tax law is enormously complicated. I have tried to give a fairly full answer that can assure people who really have nothing to worry about but that can also raise a warning flag for those fortunate enough to have something to worry about here. If you find yourself coming anywhere near the estate tax exemption amounts, or if you have questions about whether you do, you should meet with a lawyer to discuss estate planning.