ber, give a factor of 10, the value of the annuity for estate tax purposes would be $30,000. In the case of a retired flag or general rank officer who has elected the maximum one-half benefit for his wife and if the wife is relatively young at date of his death, the benefits to her under the Family Protection Plan could be valued at over $70,000.10 At the time of writing, the Treasury Department is studying a DOD request for reconsideration of a Revenue Ruling and there is a legislative proposal, DOD 87-81 "Contingency Option Act, Amend to Provide Tax Exemption", to alter the tax impact on benefits under the Protection Plan. Other miscellaneous type items that may be included in a decedent's gross estate, even though in some instances they might not be items subject to probate procedures or subject to provisions of a will, are the following: gifts or certain property transferred during his lifetime without adequate consideration, property over which the decedent had a general power of appointment," annuities, dower or curtesy of a surviving spouse or a statutory estate in lieu thereof, debts due the decedent, interests in business, insurance on the life of another, accumulated dividends, post mortem dividends and returned premiums on insurance, claims, rights, royalties, leaseholds, reversionary interests, household and personal effects, etc.12 Benefits paid to survivors after death of a serviceman which are not part of his estate, for Federal estate tax purposes, include pensions or compensation paid to survivors by the Veterans Administration;13 Armed Forces gratuity pay, which was held not to constitute property of the decedent for Federal estate tax purposes;14 amounts payable under the Social Security Act to the widow, children, or parents of a "fully insured" or "currently insured" decedent,15 and since the above benefits are not part of the estate of a deceased serviceman, but a benefit paid by the Government to his surviving widow, children or dependent parents, such benefits should likewise not be part of his estate for purposes of State death taxes. FILING OF FEDERAL RETURNS A Federal estate tax return must be filed for the estate of every citizen or resident of the United States whose gross estate, including all 10. For a detailed discussion of COA or Protection Plan benefits [10 U.S.C. 1431-1446 (1958)], see JAG JOURNAL of March 1961, "The Tax Impact of the Contingency Option Act." 11. IRC 1954, section 2035-2038, 26 U.S.C. §§ 2035-2038 (1958). 12. Instructions for Schedule F, U.S. Estate Tax Return, Form 706. 13. Section 1001, Veterans' Benefits Act of 1957, P.L. 85-56, 38 U.S.C. § 3101 (1958). 14. Rev. Rul. 55-581, CB 1955-2, p. 381. 15. ET 18, CB 1940-2, p. 285; Rev. Rul. 55-87, CB 1955-1, p. 112. types of property described by statute, such as that discussed above as being subject to tax, exceeded $60,000 in value at the date of death.16 The return must be filed within 15 months after the date of the decedent's death, even though there may be no tax due because of deductions and exemptions.17 The property left by a deceased may be subject to claims for debts, medical and funeral expenses, expenses incurred in administering property subject to claims and for mortgages and liens. The administrator or executor of the estate is liable for paying such claims against the estate and these payments are deducted from the gross estate, leaving what is called the "adjusted gross estate." The marital deduction, if any, is deducted from the adjusted gross estate and the $60,000 basic exemption is then deducted to arrive at the "taxable estate." MARITAL DEDUCTION One of the most important deductions available to estate planners for the purpose of avoiding Federal estate taxes is the marital deduction provided by section 2056 of the Internal Revenue Code of 1954. The maximum marital deduction allowable is equal to one-half of the adjusted gross estate. To qualify, property must pass to the surviving spouse either outright or as a life interest with a general power of appointment. As mentioned above, the "adjusted gross estate" is generally the gross estate less debts and administration expenses. If full advantage is taken of the marital deduction, an adjusted gross estate would have to be over $120,000 before there would be any Federal estate tax assessed. The technicalities surrounding the "marital deduction" could be the subject of several JAG JOURNAL articles, but in brief, if the surviving spouse, man or woman, has only a life interest with no right or power to say who gets the corpus or principal upon his or her death, or if the surviving spouse's interest is "terminable" or could be terminated by certain occurrences, such an interest would not qualify for the marital deduction. Interests which qualify for the deduction, however, are not limited to property received outright under a will. For example, life insurance proceeds payable to a surviving spouse may qualify; a survivor's rights in jointly owned property or property owned by entirety could qualify; dower and curtesy rights 16. IRC 1954, 26 U.S.C. § 6018 (1958); Reg. section 20.6018-1 (1962). 17. IRC 1954, section 6075, 26 U.S.C. § 6075 (1958). Also, a preliminary notice must be filed within two months of decedent's death if no executor or administrator qualifies within that period; or if one qualifies, within two months of death, the preliminary notice must be filed within two months of the qualification. 26 U.S.C.6071 (1958); (Treas. Reg. § 20.6071-1) (1962). or a statutory interest in place of such rights could qualify; benefits payable under option 1 (to wife) or 1 and 4 (added provision 4 to terminate withholdings if wife dies first) of the Retired Serviceman's Family Protection Plan (formerly COA) would qualify for the marital deduction, but option 2 (benefits for children) would not; the option 3 benefits (wife and children) under the Protection Plan would probably qualify for marital deduction benefits if there was no eligible child on the date of death of the member, since all possible benefits would be the widow's.18 MARITAL DEDUCTION ILLUSTRATED The value of the marital deduction for Federal estate tax purposes is best shown by an example. The tax brackets for the tax range from 3% to 77%, so the relative effect or benefit of any deduction increases with the size of the taxable estate. To limit the example to a realistic estate for a serviceman who has invested well or has inherited a moderate amount of property, an estate of about $155,000 will be used. Assuming debts, doctor bills, funeral and administration expenses are approximately $5,000, a gross estate of $155,000 would be reduced to $150,000. This $150,000 is referred to as the "adjusted gross estate." It is this amount which determines the maximum marital deduction. Everything left to the surviving spouse up to the maximum of one-half of the adjusted gross estate, as mentioned above, qualifies for the deduction. This leaves $75,000 from which is deducted the basic $60,000 exemption, leaving $15,000, which is the "taxable estate." The Federal estate tax on $15,000 would be $1,050. Suppose, on the other hand, that insurance was made payable so that all the surviving spouse receives is a life interest, that the benefits payable under the Family Protection Plan option 3 do not qualify for the marital deduction, and that all other property was left in trust, income to wife, remainder to children, so that no appreciable amount of property qualifies for the marital deduction. The only deduction from the $150,000 adjusted gross estate would be the $60,000 basic exemption, leaving a taxable estate of about $90,000. The tax on that amount would be $17,900, or $16,850 more than if full advan18. P-H Fed., Est. and Gift Taxes Vol., § 120,570 (50) lists property interests qualifying for the marital deduction and cites IRS Letter, 5-12-49, as follows: Marital deduction allowable for annuity paid to surviving spouse under retirement or pension plan where all amounts payable under the contract are receivable by the spouse and terminate with her death, and no other person may thereafter possess or enjoy any part of the property. tage had been taken of the marital deduction. Taking full advantage of the marital deduction may not always be the best estate planning so far as taxes are concerned. This is illustrated by an example given in Prentice-Hall Executives Tax Report of November 13, 1961: Assume a husband has an estate of about $120,000 and his wife has a separate adjusted gross estate of about $80,000. If the husband dies first, taking the maximum marital deduction by leaving $60,000 to his wife and the rest to his son, and if the wife dies later leaving all to their son, the son eventually gets $184,900. If the husband and wife each leaves everything directly to their son, he gets $188,900. But, if the husband takes a marital deduction of only $20,000 by leaving that amount to his wife, the son eventually gets $190,400. STATE DEATH TAXES As mentioned earlier, most attention in estate planning is directed toward the Federal estate tax, but State death taxes should not be ignored. In general, it is the State of domicile of the deceased where a will is probated or an estate is administered, where the death tax will be assessed; however, if real property is owned in States other than the deceased owner's domicile or if he owns tangible personal property situated in other States, such property is normally subject to tax in the State where situated rather than the State of domicile. In the case of a serviceman dying on active duty, section 514 of the Soldiers and Sailors Civil Relief Act 19 would apply to personal property and it is deemed not to be located, for tax purposes, in any State other than his State of domicile. This adds another reason to those given in JAG NOTICE 5840 of 21 December 1961, for being consistent in treating one State as your domicile. If a serviceman is inconsistent, it is possible his estate may pay death taxes to more than one State on the same property. A serviceman should be sure the State specified in his will is actually his domicile. He could not specify a State in which he has never lived, for example, and thereby make it his domicile. Also, it is normal procedure for records to be checked to see that a decedent has paid applicable State income and property taxes, and if not, the widow may find that such back taxes have been deducted before the estate is distributed to her. Because an individual has escaped State income or property taxes while alive, does not mean his estate will. Exemptions, tax rates and the many other details involved vary from State to State and it is not possible to discuss them at length in this 19. 50 U.S.C. App. § 574 (1958). article. The difference in death taxes between States can be illustrated by considering an uncomplicated estate as it would be taxed if situated in either California, Virginia or Florida (three popular retirement States). For even the most simple situation, it would take many pages to go into detail for each State, but we can mention a few of the more important rules. California is a community property State so that half of everything the husband acquired during marriage (with a number of exceptions) is considered to be the wife's property and that half is therefore not subject to tax on husband's death (and vice versa). A recent amendment to the California law has provided an additional benefit in connection with community property. Effective September 15, 1961, none of the community property transferred to a spouse is subject to the California Tax, unless, on the death of the husband, the wife is given by will either a life estate or a general or special power of appointment in conjunction with the one-half of the community property subject to the testamentary disposition of the husband. Virginia and Florida are not community property States, but have other exemptions that California may or may not have. California exempts $50,000 of insurance payable to named beneficiaries whereas Virginia exempts all insurance payable to named beneficiaries. Insurance payable to the estate, so that it would be distributed in accordance with the will, would be taxable in all three States. Virginia, Florida and California follow the Federal rule that property owned in joint ownership (assuming it is not community property) is presumed to be the property of the deceased unless the survivor can show he or she actually contributed to or owned a portion or all of the property originally and then, to that extent, it is not taxed as part of the estate of deceased.20 Florida has only a "pick-up" estate tax, so that there is a tax paid to Florida only if the estate is large enough (at a minimum, over $100,000) to qualify for a deduction under the Federal law for death taxes paid to a State. The Florida tax should result in no additional expense (other than the cost of making up the return) to the estate, because any tax paid to Florida would result in a credit against that 20. Some States, such as Wisconsin, treat jointly owned property as being owned in proportion to the number of owners, i.e., 50-50 if two owners, regardless of who paid for it. If husband dies, only half the value would be included in his estate even though he paid for all; and if wife dies, half would be taxable in her estate even though she had contributed nothing. In other States, such as Maryland and Pennsylvania, jointly owned property passing to a surviving spouse is entirely exempt from the inheritance tax. owed under the Federal estate tax.2 21 For purposes of illustration, let's assume a retired serviceman dies leaving property composed entirely of money, taxable securities and real property, all situated for tax purposes in one of the three States we are considering, and an adjusted gross estate, as defined above, valued at about $150,000. If everything is left to the widow the death taxes would be approximately as follows: Federal Estate Tax-$1,050 California Inheritance Tax-$0 to $6,650 depending The above figures would of course change with any of a great number of circumstances and, for the Virginia and California inheritance taxes, with the class of beneficiaries (i.e. children, brothers or sisters, etc.).22 Depending on how the property is owned and willed, the tax in California could be less or more than if living in Virginia. The example is given merely to illustrate that choice of domicile or where an individual is living and domiciled at time of death can make a difference in death taxes. The impact of State death taxes is even more obvious in larger estates. The following example uses four States and a variation of a situation used in a Prentice-Hall 23 example. Assume that a successful executive leaves an estate-after debts and expenses-of $700,000 to his wife, taking full advantage of the marital deduction. Four State death taxes on such an estate are compared to show how choosing a domicile can affect the size of an estate, after taxes. The above example also illustrates that if an individual's domiciliary status becomes so "fouled-up" that two or three States are able, under their laws defining residence or domicile for tax purposes, to assess death taxes, the re 21. Comments are based on State laws as summarized in CCH Tax Reporters of the respective States. 22. Tax rates under the California inheritance tax vary, depending on the size of the estate and class of beneficiary, from 2% to 24%. The rates under the Virginia law vary, depending on the size of estate and class of beneficiaries, from 1% to 15%. Rates under the Florida law depend on the maximum available credit under the Federal estate tax law. 23. P-H Executives Tax Rpt., Sept. 18, 1961. sults could be catastrophic so far as the estate plan is concerned.24 GIFT TAXES There are a great number of ways to reduce the size of an estate to minimize the impact of death taxes, but whether they would accomplish the desires of the owner or testator depends on all the circumstances. The most obvious way to cut down the size of an estate is to make gifts, either via trusts or outright. Here again the laws of the State of domicile would have to be examined to determine whether a State gift tax is applicable.25 For Federal gift tax purposes, no gift tax return would have to be filed by any donor unless gifts to any one individual totaled over $3,000 in one year.26 Under various State laws it may be that a return is required for much smaller gifts. Under the Federal law, in addition to the $3,000 annual exclusion per donee there is a $30,000 life time exemption for gifts.27 The tax, after exclusions and exemptions, is imposed on the donor. It is his responsibility to file the return if gifts totaling more than $3,000 are made to any donee during the year. There is a marital deduction for gifts similar to that discussed for the Federal Estate Tax, so that if a qualifying gift is to the donor's spouse, 50% is exempt.28 For example, a husband could give $66,000 in one year to his wife without becoming liable for a Federal gift tax, although a return would be required. It works out this way-one-half of the $66,000 is exempt by reason of the marital deduction; of the remaining $33,000, $3,000 is excluded under the annual exclusion and the $30,000 lifetime exemption (assuming none of the exemption has been previously used) exempts the remainder. If a husband makes a gift to a child or any other individual, and if his wife joins in the gift, or consents to gift-splitting, her exemption and exclusion can be added.29 Therefore, a husband, joined by his wife, could make a gift totaling $66,000 in one year to one child without becoming liable for a gift tax, although re 24. See JAG JOURNAL of Feb. 1957, "Residence and Domicile of Servicemen," in which mention is made of the case of Texas v. Florida, 306 U.S. 398, where Texas, New York, Florida, and Massachusetts all claimed a deceased as a domiciliary. If the death taxes of all four States and the Federal estate tax had been paid, the entire 44 million dollar estate would have been consumed. 25. Twelve States have gift taxes: California, Colorado, Louisiana, Minnesota, North Carolina, Oklahoma, Oregon, Rhode Island, Tennessee, Virginia, Washington, and Wisconsin (1962 Martindale Hubbell Law Directory, Vol. IV Law Digests). 26. IRC 1954, section 2503, 26 U.S.C. § 2503 (1958). 27. IRC 1954, section 2521, 26 U.S.C. § 2521 (1958). 28. IRC 1954, section 2523, 26 U.S.C. § 2523 (1958). 29. IRC 1954, section 2513, 26 U.S.C. § 2513 (1958). turns would be required to be filed by both spouses. By filing returns in which one spouse consents to the gift by the other, they are in effect each making gifts of $33,000, each has the $3,000 annual exclusion and a $30,000 specific exemption. The $30,000 exemption may be used only once, but the $3,000 exclusion applies each year to each donee. If no gifts are made during the year, the "exclusion" is lost. Even though husband and wife have given $66,000 to one child, for example, and used up their respective "exemption", they could in future years each give $3,000 to any number of individuals and take advantage of their annual "exclusions." If they had five children, husband and wife could each give $3,000 to each child tax free, or a total of $30,000 in one year without becoming liable for a Federal Gift Tax. Whether there would be a State gift applicable would depend on the law of the State of domicile of the donor or donee, depending on where the gifts were made. Gifts made within three years of death are presumed to be in contemplation of death for Federal estate tax purposes.30 It could be longer or shorter under State death tax laws. This means that a gift made within three years of death would be included within the estate of the deceased donor for estate tax purposes unless the estate representative could prove that the gift was not made in contemplation of death. For this reason gift practices of the decedent in prior years are important in rebutting any presumption of a gift made in contemplation of death. Any gift tax paid would be credited toward the estate tax computed on the value of a gift included within the estate. Assuming gifts over the amount of the annual exclusion and lifetime exemption are made, the gift tax rates basically are 75% of the estate tax rates, but are cumulative in nature. If gifts over the amount of the exclusion and exemption are made so that there are taxable gifts made in successive years, the taxable gifts made in previous years are added before figuring the tax rate on the current year's gifts. This means that a point may be reached where the gift tax would be larger than if the same property passed to beneficiaries by inheritance and was subject to estate taxes. To avoid being included within an estate for death tax purposes, a gift must be bona fide. It cannot be a sham with the donor retaining a beneficial interest, a reversionary interest or complete control. 30. IRC 1954, section 2035, 26 U.S.C. § 2035 (1958). GIFTS TO MINORS A relatively recent development in the gift field is the Uniform Gifts to Minors Act which has been adopted by 47 States. The other 3 States (Alaska, Georgia, New Jersey and D.C.) have Model Gift laws, so that it is possible in any State to make gifts to minors without formal trust or guardianship complications. Under the Uniform Act, a gift of registered securities may be made by a donor's buying stock, for example, and registering it in his own name as custodian, under the Uniform Gifts to Minors Act of his domiciliary State, for the named minor. The Uniform Act prescribes details, which may vary slightly from State to State, concerning powers of the custodian to sell and reinvest, requirements concerning delivery of property to the donee or successor custodians, procedure to follow in case of death of donor-custodian or donee, etc. Bearer securities may be given by naming a third party as custodian, who could be an adult member of donee's family or a guardian of the minor in Model Law States or any other adult person or a trust company in Uniform Act States. The gift of bearer securities is accomplished by their delivery to the designated custodian accompanied by a Deed of Gift, the form for which is specified by the State law. The donor cannot make himself custodian of bearer securities. Gifts under the Uniform Act are irrevocable. A parent cannot register securities in the name of his son, with the parent as custodian, and then later change his mind and use the stock for his own, the parent's purposes. The Internal Revenue Service has ruled that if income from stock given in this manner is used in discharge of a legal obligation of any person to support a minor, such as for the support, education or other expenses normally required from a parent for his child, such income is taxable to the one liable for support.31 The Service has also ruled that if the donor-custodian dies before the child reaches 21, the value of the stock or security is included in the estate of the donor for estate tax purposes.32 Income received from securities or investments given under the Uniform Act is taxable to the minor-owner currently, not to the donor or custodian, unless the income is used to relieve a legal obligation of the parent. The income need not be distributed but may be accumulated for delivery to the donee when he or she reaches 31. Rev. Rul. 56-484 and Rev. Rul. 59-357. 32. Rev. Rul. 57-366 and Rev. Rul. 59-357. 21. Assuming the income and/or principal are used for college in later years, if the child's income or principal used for his education are in a greater amount than that contributed by the parent, it could be that the child will no longer qualify as a dependent because of the 50% support test.33 CONCLUSION There are almost unlimited possibilities and arrangements that may be followed to take advantage of exemptions or to reduce the size of estates through inter vivos trusts and gifts so as to avoid death taxes, but these should not be attempted without expert advice, preferably from lawyers specializing in estate planning. There is always the danger that attempts to avoid taxes may result in defeating the overall desires of a testator and that a saving on taxes may be less important than other considerations. This is especially true in relatively small estates. The overall expense resulting from trusts and attorneys' fees in the probate or administration of estates complicated by tax gimmicks may be more than if a simple will had been used without attempting avoidance. Also, there are many instances of elaborate tax saving schemes that were expensive to set-up and deprived the owner or donor of some or all of the income and control and then ended up being taxed anyway because of a change in the law closing a "loophole", a change in a Revenue ruling or a court decision. The examples outlined in this article illustrate why expert advice should be obtained before embarking on an estate planning program. There are many sad cases where death, gift and income taxes have been avoided, but the donor, his dependents or donees ended up with less money for their needs than if the tax considerations had been ignored. To cite one last unfortunate example, suppose a serviceman is living on his service pay or is without outside income; that he has not accumulated an estate of any size; that he has a large mortgage or deed of trust on the house he is buying and on which he is paying 6% or more interest; and that he gets ahead so that he has $3,000 in his savings (Continued on page 128) 33. " .. in the area of higher education, it is safe to say that the parent's obligation to provide support for education would end, in every State, prior to the college level ... .... The amount of trust income used in paying the tuitional cost of a college education for the child would not be taxable to the parent because the payments do not discharge any legal obligation imposed upon the parents by local law. However, the parent would be chargeable with the portion of trust income used in paying the child's room and board at college, since these payments would be in discharge of his legal obligation to provide support." (Commerce Clearing House, Inc. Standard Federal Tax Reports, Vol. XLIX, No. 24, 16 May 1962, Part I, p. 12). |