The Gross Estate

Example:  Ronald transferrred Blackacre to George for life, remainder to George Jr. and his heirs.  George died.  Although George "owned" a life estate in Blackacre at death, his death extinguished this interest and George Jr.'s remainder passed not from George but from Ronald. Thus, there is no tax exposure to George's estate under 2033.

Distinguish:  Rule only applies to interests conveyed to the decedent by another.  Transfers by the decedent with a retained life estate are taxable in the decedent's estate under 2036.

 Why are Certain Lifetime Transfers Includible in

the Gross Estate?

If the estate tax applied only to property owned or passing at death, it might be possible for a person to make lifetime transfers of property with retained benefits or controls, and thereby retain some of the economic benefits of ownership without incurring an estate tax. It also might be possible to make a gift of a life insurance policy shortly before death, with the policy valued at its cash surrender value for gift tax purposes, and thereby remove the policy proceeds from the insured's gross estate. 

The "lifetime transfer" sections of the Internal Revenue Code operate to prevent estate tax avoidance through such transfers. 

Certain Lifetime Transfers made within 3 years that are Includible in the Gross Estate

Transfers of Life Insurance within 3 years of Death

General Rule 2042:  Life insurance proceeds on the decedent's life are includible in the gross estate if the proceeds are:

(1) payable to (or for the benefit of) decedent's estate; or (2) payable to any other beneficiary, but only if the decedent possessed "incidents of ownership" at the time of death.

If the insured transfers incidents of ownership within 3 years of death, the proceeds will be taxed in his estate.

Irene is the insured under a $500,000 life insurance policy that names her son Joe as beneficiary. Having developed a hacking cough, and realizing that the $500,000 in insurance proceeds will be taxed in her estate if she owns the policy at her death, Irene gives the policy to Joe by assigning the policy and its incidents of ownership to him. The cash surrender value of the policy is $28,000 at the time of the gift. Irene dies two years later, and the $500,000 is paid to Joe.  How much of the proceeds are includible in Irene's estate?

Answer:  The full $500,000 is includible in Irene's gross estate because the insured made a gift of the policy within three years of death. (The obvious purpose of this rule is to prevent deathbed gifts of life insurance policies that otherwise would remove the policy proceeds from estate taxation.)  Compare:  If, however, Irene died more than three years after transferring the policy, the proceeds would not be taxed in her estate: She would not have owned the policy at her death, and the policy would have been transferred more than three years before the insured's death. Only the adjusted taxable gift of ($28,000 minus $13,000 annual exclusion =) $16,000 would be included in the estate tax computation. 

Section 2037 taxes "transfers taking effect at death." The caption of this provision suggests that it might have a broad reach, and that §2037 might apply to any number of transfers in which succession to economic enjoyment "takes effect" at death. This is not the case, however. Section 2037 applies only to transfers in which the transferor retained a reversionary interest whose value exceeds five percent of the value of the property, and then only if someone's taking is contingent on surviving the transferor. (That sounds complicated -- and it is!) Fortunately, relative few situations are reached by §2037, and this provision is pretty much of a dead letter in estate planning. 

The gross estate includes transfers with a retained life estate. [§2036(a)(1)], since the transferor has retained the most valuable stick in the ownership "bundle": The right to enjoy the property, or its income, for life. In addition to catching transfers in which a life estate is expressly retained, the statute reaches transfers in which retention of a life estate is implied from the circumstances or from the conduct of the parties. 

Example:  Mary gives her house to her son John, but in the deed of gift reserves the right to possess, occupy or rent the house for the rest of her life. Is Mary's house includible in her estate?

On Mary's death the date-of-death value of the house is includible in her gross estate. 

What is the "gross up rule"?

Although a gift made within 3 years of death is not included in the donor's estate, any gift taxes paid or payable with respect to such gifts are includible.  

This rule applies to all gifts.

The purpose of this "gross up" provision is to prevent an individual who expects to die shortly from making a taxable gift of property in order to keep the amount of the gift tax out of the estate and thus pay a lower estate tax.

The gross estate includes transfers with a retained power to revoke, alter, amend or terminate the transfer. Thus the value of assets settled in a revocable trust is includible in the transferor's gross estate. However, the power to "alter, amend or terminate" can be a bit trickier. 

Example:  Dick deposits funds in an “A, trustee for B” savings account, called a Totten Trust bank account. The account is taken in the name of "Dick Rogers, trustee for Nellie Rogers." (Nellie is Dick's niece.) On Dick's death several years later, there is $18,000 on deposit in the account?  Are the funds includible in Dick's estate?

Yes, the sums payable to Nellie, are includible in Dick's gross estate. Under the banking laws that apply to Totten Trust accounts, Dick could have withdrawn the amounts on deposit at any time. Thus he held a power to revoke the transfer. 

Example: Martha uses separate property to buy securities for $13,000, and causes the securities to be registered in the name of "Martha Green, custodian for Susie Green, under the Texas Uniform Transfers to Minors Act." (Susie is Martha's 10-year-old daughter.) Martha has made a gift to Susie, but she doesn't have to file a gift tax return because the total of her gifts to Susie during the calendar year were within the $13,000 per-donee annual exclusion under the gift tax. Martha dies six years later; the AT&T stock is worth $25,000 at her death. Martha was still serving as UTMA custodian at her death since Susie was 16 years old. Is the gift includible in Martha's estate and, if so, how much?

Yes, the $19,000 is includible in Martha's gross estate. True, Martha could not revoke the transfer; UTMA gifts are irrevocable. However, a UGMA custodian has very broad discretionary powers to distribute the custodial property or its income to the beneficiary. The courts have held that the discretionary power to make (or not make) distributions is a power to alter the disposition. Also, since a custodian can distribute "so much or all" of the custodial property as she deems appropriate, Martha could terminate the disposition by distributing all of the property to Susie. The fact that Martha didn't exercise the power to terminate is irrelevant; it is the existence of powers, not their exercise, that controls taxation. Martha could have named someone else as trustee to keep the proceeds out of her estate (this would have been an irrevocable gift).

Example:  Elaine transferred property in trust with directions to pay the income to Jerry for life, then to Kramer for life, remainder to George.  Elaine reserved the right to designate additional income beneficiaries or remaindermen if she survived Jerry.  If Elaine predeceases Jerry, what part of the property, if any, is includible in Elaine's estate?

Answer: No part of the property is taxable under Section 2038 since Jerry's death is not within the control of Elaine and the condition did not occur by the time of Elaine's death.

Darby declares herself trustee of certain property. Under the terms of the trust, the trustee must pay income to Arthur during Arthur's life and distribute the corpus to Xavier after Arthur's death provided, however, that the trustee may invade the corpus and make distributions to Arthur "to the extent necessary to maintain Arthur in his accustomed manner of living."  Is the power includible in Darby's estate?

Answer:  No. Since there is a fixed external standard (Arthur's accustomed manner of living), the excercise of the power is nondiscretionary and the transfer is not includible in Darby's estate.

What is an ILIT?

What are the advantages of an ILIT?

(1) Removes life insurance proceeds from Grantor’s estate (if Grantor is not insured or, if insured, is not Trustee over the life insurance policy);

(2) Proceeds available but not required to provide liquidity to Grantor’s estate (by loan or purchase) to pay estate taxes or purchase assets Grantor would rather have out of estate (i.e., family business).

(3) Distribution of trust property can be coordinated with Grantor’s overall estate plan.

(4) Cash value and proceeds removed from liability for Grantor’s debts if: (a) Grantor is not insolvent immediately after gifts to trust; or (b) Gifts to trust are not made with intent to defraud Grantor’s creditors (present or future).

(5) Fund obligations of Grantor remaining at death (such as alimony or child support or other continuing obligations of the Grantor’s estate).

(6) Provide for advance distribution to beneficiaries when surviving spouse of Grantor is close in age to other beneficiaries (second marriage situation).

(7) Benefits and protections provided by irrevocable asset trust as listed above.

What are the disadvantages of an ILIT?

Disadvantages

(1) Trust is irrevocable and Grantor must part with complete control of life insurance policy owned by the trust.

(2) Grantor cannot be Trustee over the life insurance policy without inclusion in Grantor’s estate.

(3) Beneficiary (or managing conservator parent in divorce situation) may withdraw gifts to trust as they are made, if Grantor wants gifts to qualify for annual exclusion.

(4) Beneficiary notices are required upon each gift to trust.

(5) Complex rules as to beneficiary regarding lapse of withdrawal rights in excess of $5,000 per year.

(6) Legal, accounting and time expense in establishing and maintaining trust and in following proper funding procedures.

(7) Potential adverse tax consequences to Grantor and beneficiaries. (a) Life insurance proceeds may be included in Grantor’s estate if Grantor dies within three years of the trust’s receipt of the life insurance policy. (b) Grantor must use some of his or her unified credit if: 

i. A gift to the trust exceeds the annual exclusion amounts available to the Grantor for gifts to the Crummey beneficiaries of the trust;

ii. If the Crummey beneficiaries are not the ultimate beneficiaries of the irrevocable trust or if the gifts made to the trust are not subject to Crummey Withdrawal Power. If the total amount of such gifts exceeds the unified credit, gift taxation will occur.

(c) Trusts will be subject to generation-skipping transfer tax to the extent that proceeds from the trust pass to the grandchildren or later descendants of the Grantor and either: i.

ii. The trust has more than one beneficiary or, if the trust has only a single beneficiary, but the trust assets are not includable in the single beneficiary’s estate upon death; or The Grantor has not applied a portion of his Generation-Skipping Transfer Tax exemption to the gifts made to the trust. 

The Marital Deduction

General Power of Appointment

Trust (“the 2056(b)(5) Trust”) 

Transfer to Trust will qualify for marital deduction if: