Death and Taxes: A Potpourri of Basic Federal Tax Rules

Pre-death gifts that are in excess of $13,000.00 per person per calendar year reduce the amount that can be left behind as a tax-free inheritance. Someone who does not exceed that amount with gifts can leave $1,000,000.00 free of Massachusetts estate tax as an inheritance. For example, if a person makes a pre-death $15,000.00 gift, the first $13,000.00 is excluded but the extra $2,000.00 causes the post-death amount that can be left behind free of federal estate tax to be reduced to $998,000.00.

Married persons can now leave up to $2,000,000.00 under Massachusetts tax law to their heirs if the first to die does not leave $1,000,000.00 directly to the surviving spouse. If everything is left directly to the surviving spouse, only one-half of these amounts can be left to the heirs free of Massachusetts estate tax. Thus, owning everything in joint names and naming the spouse as beneficiary of everything to avoid probate can often be a mistake.

Non-U.S. citizens are affected by many estate and gift tax exceptions. Whereas a spouse of a U.S. citizen can receive unlimited gifts, as of 2009 a non-U.S. citizen spouse was limited to receiving $133,000.00 per calendar year, as indexed for inflation. A surviving spouse who is a non-U.S. citizen cannot defer payment of federal estate taxes without the establishment of a Qualified Domestic Trust (QDOT). For practical purposes, a QDOT can be ineffective unless a bank is a Trustee.

A home or vacation home can be placed into a qualified personal residence trust (QPRT), through which a discounted gift can be effectively made if the person establishing the QPRT survives the term of years selected. The discount on the gift is based on IRS actuarial tables.

Business interests can be valued at a discount on the decedent’s federal estate tax return due to concerns about marketability or a minority interest. Business interests can also result in a favorable, low-interest deferral of federal estate taxes.

The proceeds of a life insurance policy are subject to the federal estate tax if the insured person has any of the “incidents of ownership.” To avoid the federal estate tax on the proceeds, a life insurance policy can be placed in an irrevocable trust, but the transfer of an existing policy remains subject to the federal estate tax for three (3) years after the transfer. To be tax-free without a 3-year wait, it is best that new policies be applied for and purchased by the trustee of the irrevocable trust.

On a gift, the recipient has a carryover basis for capital gains tax and depreciation purposes. On an inheritance, the recipient usually has a stepped-up basis (That was the law until the end of 2009, and will be the law again in 2011 and beyond, but not in 2010 as long as Congress fails to act to repair the federal estate tax mess it created 9 years ago). Pre-death gifts should not be made without factoring in these tax rules. Pre-death transfers can sometimes be made to avoid probate without resulting in a carryover basis.