Chapter 39
Gift and Estate Tax Planning Basics

Gift planning can be an important part of estate planning. This chapter provides an overview of the federal gift tax and estate tax. Developing an estate plan for your assets requires professional assistance, but the basic guidelines in this chapter can help you begin to estimate your potential estate and start thinking about property transfers that may reduce or avoid the estate tax.

Relatively small gifts can completely avoid gift tax (39.2) because of the annual gift tax exclusion, which for 2017 is $14,000 per donee. Gifts to a spouse and certain gifts to pay educational or medical expenses also are not subject to the gift tax.

Gift tax (39.4) generally does not have to be paid even on very substantial taxable gifts because the tax is offset by a tax credit that for 2017 effectively exempts up to $5,490,000 of taxable gifts from the tax.

The credit for gift and estate taxes is unified, so the same exemption of $5,490,000 applies to the estates of those dying in 2017, to the extent that the exemption was not used to offset lifetime taxable gifts. An unlimited estate tax marital deduction is allowed for transfers to a citizen spouse. The estate of a married individual can make a portability election that allows any portion of the decedent’s unused exemption amount to pass to the surviving spouse.

39.1 Gifts of Appreciated Property

Making a gift of appreciated property to a family member in advance of an anticipated sale can reduce the income tax liability for the family as a whole. By making a gift of interests in the property to several family members, it may be possible to spread the profit and the tax among a number of taxpayers in low tax brackets. Depending on the value of the property, you may or may not have to file a gift tax return (39.2).

However, the tax benefit of making gifts of property to younger family members has been cut back by the expansion of the “kiddie tax.” The kiddie tax (24.2) now covers most 18-year-olds and college students age 19 to 23.

Do not make a gift of investment property such as stock that has decreased in value if you want a deduction for the loss. Once you give the property away, the loss deduction is gone forever. Neither you nor your donee can ever take advantage of it. The better way is first to sell the property, get a loss deduction, and then make a gift of the proceeds.

Warning: The IRS may claim that the gift was never completed if, after sale by the donee, you control the sales proceeds or have the use of them.

39.2 Gift Tax Basics

You can make substantial gifts of cash or property without incurring gift tax liability because of exclusions allowed by the tax law. Even where a gift exceeds the available exclusions and is technically subject to the gift tax, liability computed on Form 709 can generally be avoided by applying the lifetime credit, which for 2017 effectively exempts up to $5,490,000 of taxable gifts from the tax (39.4).

The annual exclusion and other tax-free gifts. Gift tax liability may be avoided by making gifts that do not exceed the annual exclusion. The annual exclusion applies separately to each donee to whom you make gifts during a calendar year. For gifts made in 2017, the per-donee exclusion is $14,000, or $28,000 if your spouse consents on Form 709 to “split” your gifts. The annual exclusion is allowed only for cash gifts or gifts of present interests in property; gifts of future interests do not qualify. For gifts made in 2018, the annual exclusion might be increased above $14,000 by an inflation adjustment; seethe e-Supplement at jklasser.com for an update.

Gifts to your spouse are completely tax free under the gift tax marital deduction if your spouse is a U.S. citizen at the time of the gift. For gifts to a spouse who is not a U.S. citizen, there is an annual exclusion, which for 2017 gifts is $149,000, provided that the $135,000 excess over the basic $14,000 annual exclusion otherwise qualifies for the marital deduction.

There is an unlimited gift tax exclusion for payments of another person’s tuition or medical expenses, if you make the payment directly to the educational organization or care provider. The medical and educational exclusions are allowed without regard to the relationship between you and the donee for whom you are making the payments. The exclusion for directly paid educational expenses applies only to tuition, not to room and board, books, or supplies.

Contributions to a qualified tuition program (QTP; see33.5) on behalf of a designated beneficiary do not qualify for the educational exclusion, but do qualify for an enhanced annual exclusion. You can elect to treat a QTP contribution over the basic annual exclusion as if it were made ratably over a five-year period, but only up to five times the annual exclusion. For example, a QTP contribution made in 2017 of up to $70,000 may be treated as if 1/5, or $14,000, had been contributed in 2017 and in each of the next four years. Thus, the entire gift up to $70,000 can avoid gift tax and if your spouse consents to split the gift on Form 709 (39.3) the exclusion increases to $140,000. If you make QTP contributions for more than one person in the same year, you can make the special QTP election for each of them.

Taxable gifts. If you make a gift that exceeds the allowable annual exclusion and which is not otherwise exempt from the gift tax, you must report the gift on Form 709 (39.3). Table 39-1 (39.9)shows the tax rates applicable to taxable gifts made in 2017 and later years. However, the tax as computed using the rate table can be offset by the allowable credit (39.4).

Basis for property received as gift. The basis for appreciated property received as a gift is generally the same as the donor’s basis. If gift tax was paid by the donor, basis is increased. The basis computation is explained in 5.17.

39.3 Filing a Gift Tax Return

A gift tax return generally must be filed on Form 709 for a gift made during 2017 to an individual other than your spouse if it exceeds $14,000 or is a gift of a future interest (regardless of value). A return does not have to be filed for gifts qualifying for the tuition or medical expense exclusion discussed in 39.2.

Married couples who want to split gifts of over $14,000 in 2017 to any one person must report the gifts to the IRS on Form 709 and the consenting spouse must sign the consent in Part I. No gift tax is due under the annual exclusion if the “split” gift is $28,000 or less.

Form 709 for 2017 generally must be filed by April 17, 2018. If you get a filing extension (Form 4868) for your income tax return, the extension also applies to the gift tax return. If you do not request an extension for your income tax return, you can use Form 8892 to request a filing extension for your gift tax return.

39.4 Gift Tax Credit

On Form 709, any gift tax that you otherwise would owe is eliminated or reduced by a tax credit. The credit applies to lifetime gifts, so any credit that was used to offset gift tax in prior years reduces the credit available for taxable gifts made in 2017 or later years. The amount of the gifts that can pass tax free depends on the applicable credit amount allowed for the year. For 2017, the maximum credit against taxable gifts is $2,141,800, unless it is increased for a surviving spouse because a portability election (see below) was made. The $2,141,800 applicable credit amount offsets the tax (figured under Table 39-1) on the basic exclusion amount of $5,490,000 for 2017. The “exclusion amount” is often referred to as the “exemption” from tax. Since the basic exclusion amount (exemption) is subject to annual inflation increases and the credit is based on the basic exclusion amount, both amounts may increase for 2018; any increase will be in the e-Supplement at jklasser.com.

If your spouse died after 2010 and your spouse’s estate made the “portability” election on a timely filed Form 706 to transfer to you his or her unused basic exclusion amount (39.9), your maximum gift tax exclusion is increased by the unused exclusion amount from your spouse, thereby increasing your available tax credit; see the Form 709 instructions.

The basic exclusion amount and credit are “unified” for gift tax and estate tax purposes, so any basic exclusion amount/credit used to offset lifetime taxable gifts reduces the estate tax basic exclusion amount/credit that may be used by your estate (39.9).

39.5 Custodial Accounts for Minors

A minor generally lacks the ability to manage property. You could create a formal trust, but this step may be costly. A practical alternative may be a custodial account under the Uniform Gifts to Minors Act (UGMA), or the Uniform Transfers to Minors Act (UTMA), which has replaced the UGMA in practically every state.

Custodial accounts set up in a bank, mutual fund, or brokerage firm can achieve income splitting; the tax consequences discussed below generally apply to such accounts. Trust accounts that are considered revocable under state law are ineffective in splitting income.

Although custodial accounts may be opened anywhere in the United States, the rules governing the accounts may vary from state to state. The differences between the laws of the states generally do not affect federal tax consequences.

There are limitations placed on the custodian. Proceeds from the sale of an investment or income from an investment may not be used to buy additional securities on margin. While a custodian should prudently seek reasonable income and capital preservation, he or she generally is not liable for losses unless they result from bad faith, intentional wrongdoing, or gross negligence.

When the minor reaches majority age (depending on state law), property in the custodial account is turned over to him or her. No formal accounting is required. The child, now an adult, may sign a simple release freeing the custodian from any liability. But on reaching majority, the child may request a formal accounting if there are any doubts as to the propriety of the custodian’s actions while acting as custodian. For this reason, and also for tax recordkeeping purposes, a separate bank account should be opened in which proceeds from sales of investments and investment income are deposited pending reinvestment on behalf of the child. Such an account will furnish a convenient record of sales proceeds, investment income, and reinvestment of the same.

Income tax treatment of custodian account. Income from a custodian account is generally taxable to the child. However, if the “kiddie tax” applies (24.2), taxable income from a custodial account in excess of the annual “kiddie” tax floor ($2,100 in 2017) is taxed at the parent’s tax rate.

If a parent is the donor of the custodial property or the custodian of the account and income from the account is used to discharge the parent’s legal obligation to support the child, the account income is taxed to the parent.

Gift tax treatment of custodial account. When setting up a custodial account, you may have to pay a gift tax. A transfer of cash or securities to a custodial account is a gift. But you are not subject to a gift tax if you properly plan the cash contributions or purchase of securities for your children’s accounts. You may make gifts that are shielded from gift tax by the annual exclusion. The exclusion applies each year to each person to whom you make a gift. If your spouse consents to join with you in the gift, the annual exclusion is doubled. For gifts in 2017, the per-donee exclusion is $14,000, $28,000 if your spouse consents to split the gift (39.2).

If the custodial account is set up at the end of December, another tax-free transfer of up to the annual exclusion may be made in the first days of January of the following year. Assuming the annual exclusion in each year is $14,000, a total of $56,000 can be shifted within the two-month period with spousal consent.

Even if gifts exceeding the annual exclusion are made, gift tax liability may be offset by the unified credit (39.4).

Estate tax treatment of custodial account. The value of a custodial account will be taxed in your estate if you die while acting as custodian of an account before your child reaches his or her majority. However, you may avoid the problem by naming someone other than yourself as custodian. If you should decide to act as custodian, taking the risk that the account will be taxed in your estate, remember that no estate tax is incurred if the tax on your estate is offset by the estate tax credit.

If you act as custodian and decide to terminate the custodianship, care should be taken to formally close the account. Otherwise, if you die while retaining power over the account, the IRS may try to tax the account in your estate.

39.6 Trusts in Family Planning

You establish a trust by transferring legal title to property to a trustee who manages the property for one or more beneficiaries. As the one who sets up the trust, you are called the grantor or settlor of the trust. The trustee may be one or more individuals or an institution such as a bank or a trust company.

You can create a trust during your lifetime or by your will. A trust created during your lifetime is called an inter vivos trust; one established in your will is a testamentary trust. An inter vivos trust can be revocable or irrevocable. An irrevocable trust does not allow for changes of heart; it requires a complete surrender of property. By conveying property irrevocably to a trust, you may relieve yourself of tax on the income from the trust principal. Furthermore, the property in trust usually is not subject to estate tax, although it may be subject to gift tax. A trust should be made irrevocable only if you are certain you will not need the trust property in a financial emergency.

Consult with an experienced tax professional if you are considering the use of a trust.

Trust income. Where a child is a trust beneficiary, the child reports distributable net trust income as taxable income. Distributable net income may be subject to the “kiddie tax” (24.2). Income that is accumulated for the benefit of a minor child is generally not taxable and, thus, not subject to the kiddie tax.

Grantor trusts. The grantor of a grantor trust is taxed on the income of the trust. A trust is treated as a grantor trust where the grantor has a reversionary interest (at the time of the transfer) of more than 5% of the value of the property transferred to the trust. Under an exception, a grantor is not treated as having a reversionary interest if that interest can take effect only upon the death before age 21 of a beneficiary who is a lineal descendant of the grantor. The beneficiary must have the entire present interest in the trust or trust portion for this exception to apply.

Given the highly compressed tax brackets for trust income, a grantor may intentionally retain an interest in the trust property so that he or she will be taxed under the grantor trust rules. By setting up such a “defective” grantor trust, trust income may be subject to lower tax at the grantor’s tax bracket than under the trust rate schedule.

39.7 What is the Estate Tax?

The estate you built up may not be entirely yours to give away. If your estate is substantial enough, the federal government and, in most cases, at least one state government stand ready to claim their shares. The federal estate tax is a tax on the act of transferring property at death. It is not a tax on the right of the beneficiary to receive the property. If tax is due, the estate and the estate alone pays the tax, although the property passing to individual beneficiaries may be diminished by the tax.

You may not have to be concerned about a future federal estate tax liability because of the large exemption (also called the basic exclusion amount) allowed under the tax law. Current law allows a basic exclusion amount (exemption) of up to $5,490,000 for 2017 estates (39.9), and the basic exclusion amount will increase in future years with inflation adjustments. However, your potential taxable estate may be larger than you realize. The estate includes not only your business interests, real estate holdings (foreign and domestic), bank accounts, retirement accounts, stocks and bonds, mutual funds, and personal property such as art objects, but can also include life insurance, your interest in trusts or jointly held property, and certain interests you have in other estates. See 39.8 for estimating the value of your potential estate.

You will need to consult with an experienced estate tax planning professional, who can explain the potential extent of estate tax costs and help you develop a plan that can avoid or reduce those costs.

39.8 Take Inventory and Estimate the Value of Your Potential Estate

The first step in estate tax planning requires taking inventory of everything you own. Include your cash, real estate (here and abroad), securities, retirement accounts, mortgages, rights in property, trust accounts, personal effects, collections, and art works. Life insurance is includible if: (1) it is payable to your estate; (2) it is payable to others and you have kept “incidents of ownership” such as the right to change beneficiaries, surrender or assign the policy, or pledge it for a loan; or (3) you assign the policy and die within three years.

If you own property jointly with your spouse, your estate includes only one-half its value.

If you had appraisals made of specially treasured items or collections, or property of substantial value, file such appraisals with your estate papers and then enter the value on your inventory.

Retirement benefits. The gross estate includes benefits payable at your death from any of the following retirement plans: corporate or self-employed pension and profit-sharing plans, traditional IRAs, Roth IRAs, or annuities. The fact that your account balance in an IRA, 401(k), or other retirement plan is a nonprobate asset that passes outside of the estate to the beneficiaries designated by the terms of the plan does not change the fact that these assets are included in the gross estate.

Estimating the value of your assets. When you have completed your inventory, assign to each asset what you consider to be its fair market value. This may be difficult to do for some assets. Resist the tendency to overvalue articles that arouse feelings of pride or sentiment and undervalue some articles of great intrinsic worth. For purposes of your initial estimate, it is better to err on the side of overvaluation. You can list ordinary personal effects at nominal value.

If you have a family business, your idea of its value and that of the IRS may vary greatly. Estate plans have been upset by the higher value placed on such a business by the IRS. You can protect your estate by anticipating this problem in consultation with your business associates and counselors.

If your business is owned by a closely held corporation, and there is no ready or open market in which the stock can be valued, get some factual basis for a figure that will be reported on the estate tax return. One of the ways to do this is by arranging a buy-sell agreement with a potential purchaser. This agreement must fix the value of the stock. Generally, an agreement that binds both the estate and the purchaser and restricts lifetime sales of the stock will effectively fix the value of the stock for estate tax purposes. Another way would be to make a gift of some shares to a family member and have value established in gift tax proceedings.

If a substantial part of your estate is real estate used in farming or a closely held business, your executor may be able to elect, with the consent of heirs having an interest in the property, to value the property on the basis of its farming or business use, rather than its highest and best use.

39.9 Estate Tax for 2017

The estate tax is figured by the executor on Form 706, “United States Estate (and Generation-Skipping Transfer) Tax Return.” The executor must file Form 706 for the estate of an individual dying in 2017 if the gross estate, plus adjusted taxable gifts made after 1976, is more than $5,490,000, the basic estate tax exclusion amount for 2017; the term “exemption” is often used interchangably with “exclusion amount”. A timely Form 706 also must be filed, regardless of the size of the decedent’s gross estate, if the executor wants to make the portability election (see below) to permit the decedent’s surviving spouse to use the decedent’s unused basic exclusion amount. Form 706 must be filed within nine months after the date of death; an automatic six-month filing extension can be obtained by filing Form 4768.

On Form 706, the gross estate is reduced by allowable deductions. On the schedules of Form 706, deductions are allowed for funeral expenses, executor commissions, costs of preserving and distributing estate assets including attorney, accountant, and appraiser fees and court costs, debts owed by the decedent, bequests to a surviving spouse that qualify for the marital deduction, and charitable transfers. A deduction on Form 706 is also allowed for state death taxes (state estate, inheritance, legacy, or succession taxes) paid to any state or the District of Columbia on account of the decedent’s death.

The estate tax rates from Table 39-1 are applied to the taxable estate, the gross estate minus allowable deductions. If taxable gifts (over the annual gift tax exclusion) were made after 1976, the gifts are added to the taxable estate and the tax is figured on the total. The tentative tax from the rate table is reduced by the gift taxes paid or payable on the post-1976 gifts (see the Form 706 instructions). The practical effect of making the adjustments for prior taxable gifts is to reduce the basic exclusion amount and tax credit available to the estate by the basic exclusion amount and credit amounts used to offset the taxable gifts.

After making the required adjustments for lifetime gifts on Form 706, the resulting gross estate tax is then reduced by the applicable credit. The credit equals the tax on the basic exclusion amount (exemption). The basic exclusion amount for 2017 is $5,490,000 , so the 2017 applicable credit is $2,141,800, the tax on a net estate of $5,490,000 (seeTable 39-1). The basic exclusion amount is increased above $5,490,000 if the decedent is the surviving spouse of a predeceased spouse who died after 2010 and the executor of the earlier estate made the portability election on Form 706. If the basic exclusion amount is increased by the portability election, the applicable credit is also increased, so that it equals the tax on the increased basic exclusion amount.

If there is any estate tax due on Form 706 after subtracting the applicable credit (and any other available credits), the balance must be paid within nine months after the date of death, but if it is impossible or impractical to meet the deadline, a request for a payment extension may be made on Form 4768; a detailed explanation must be attached to justify the request.

Portability election. The estate of a married individual dying after 2010 can make a special portability election to benefit a surviving spouse. The election allows any part of the basic exclusion amount that was unused by the deceased spouse for gift or estate tax purposes to be left to the surviving spouse. The portable amount is called the “deceased spousal unused exclusion,” or DSUE.

The estate of a 2017 decedent makes the portability election on Part 6 of Form 706. The election is made by completing and timely filing the Form 706, including Sections B and C of Part 6. In Section C of Part 6, the estate computes the unused exclusion(DSUE) that is being transferred to the surviving spouse. The Form 706 must be timely filed (including extensions) to make the election, even if the assets of the estate are below the filing threshold of $5,490,000 for 2017. If the estate is below the filing threshold, the executor may estimate the value of the gross estate on Form 706 based on a good faith determination; see the Form 706 instructions. If an estate below the filing threshold does not file Form 706, this is treated as opting out of the election.

If the estate of a decedent with a surviving spouse is required to file Form 706 and does not want to elect portability, check the box in Section A of Part 6 to opt out.

The surviving spouse on whose behalf the portability election is made may increase his or her lifetime gift tax exemption (basic exclusion amount) by the transferred DSUE, or it will increase the basic exclusion amount available to his or her estate. If the surviving spouse who received the DSUE from a predeceased spouse died in 2017, the basic exclusion amount allowed to his or her estate on Form 706 is increased by the DSUE that was not applied against lifetime gifts. On the 2017 Form 706, the available DSUE is entered on Line 9b of Part II, and is added to the basic exclusion amount of $5,490,000 shown on Line 9a.

39.10 Planning for a Potential Estate Tax

If you have substantial assets that forseeably may exceed the basic exclusion amount(exemption)available to your estate, there are general approaches that you can take to reduce or eliminate a potential estate tax.

You can make direct lifetime gifts. Any appreciation on the property transferred will be removed from your estate. Furthermore, each gift, to the extent of the annual per donee exclusion (39.2), reduces your gross estate (39.9). Life insurance can be assigned to avoid estate tax, provided the assignment takes place more than three years before death (39.8). You can provide in your will for bequests that will qualify for the marital and charitable deductions.

The marital deduction. An unlimited marital deduction is available for property passing to a spouse who is a U.S. citizen. What should be done if you believe your spouse cannot manage property? The law permits you to put the property in certain trust arrangements that provide the surviving spouse with ownership rights sufficient to allow the marital deduction. An estate tax attorney can explain how you can protect your spouse’s interest and qualify the trust property for the marital deduction.

Life insurance proceeds may qualify as marital deduction property. Name your spouse the unconditional beneficiary of the proceeds with unrestricted control over any unpaid proceeds. If your spouse is not given this control or general power of appointment, and there is no requirement that proceeds remaining on your spouse’s death be payable to his or her estate, the insurance proceeds will not qualify for the marital deduction.

Marital deduction restrictions for noncitizen spouses. A marital deduction may not be claimed for property passing outright to a surviving spouse who is not a U.S. citizen. However, the marital deduction is allowed if the surviving spouse’s interest is in a qualifying domestic trust (QDOT). At least one trustee must be an individual U.S. citizen or domestic corporation with power to withhold estate tax due from distributions of trust corpus. The trust must maintain sufficient assets as required by IRS regulations. For the marital deduction to apply, the executor must make an irrevocable election on the decedent’s estate tax return. On Form 706-QDT, estate tax will apply to certain distributions of trust corpus made prior to the surviving spouse’s death, and to the value of the QDOT property remaining at the surviving spouse’s death. You should consult an experienced tax practitioner to set up a QDOT trust and plan for distribution provisions.

The estate of a nonresident alien is subject to estate tax only to the extent that the estate is located in the United States. A marital deduction may be claimed by the estate of a nonresident alien for property passing to a surviving spouse who is a U.S. citizen. If the surviving spouse is not a U.S. citizen, then the transferred interest must be in the form of a QDOT.

Periodically review your estate plan. No estate plan is ever really final. Economic conditions and inflation constantly change values. For this reason, your plan must be reviewed periodically as changes occur in your family and business, as when a birth or death occurs; when you receive a substantial increase or decrease in income; when you enter a new business venture or resign from an old one; or when you sell, retire from, or bring new persons into your business. A member of your family may no longer need any part of your estate, while others may need more. Material changes may occur in the health or life expectancy of one of your beneficiaries. Furthermore, tax law changes may require you to adjust your estate planning,