Richard W. Kozlowski, Esq.

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Estate Taxation - An Overview

The federal and state governments, including Vermont, have adopted various systems for taxing the transfer of wealth.  Under these systems, transfers which occur during life (see the Lifetime Gifts webpage) and at death are subject to taxation.  The estate and gift transfer tax systems are "unified," which means that gifts made during life can affect the amount of tax due upon death (see The Federal Estate Tax System, below).

Generally, the tax is imposed on the value of assets transferred, less certain deductions and expenses, and subject to certain credits.  Like income taxes, the transfer taxes are graduated, so that larger estates pay taxes at a higher overall rate than smaller estates -- in fact, many smaller estates pay no transfer taxes at all.  Estate taxes are paid by the estate, and not the recipient.

The Federal Estate Tax System

The federal estate tax system begins with the concept of the "gross estate."  Simply put, the gross estate consists of all property, real or personal, tangible or intangible, wherever situated in which the decedent had an interest at the time of his or her death.

Aside from the obvious property interests, the gross estate includes the following:

(1)    Life insurance which the decedent owned, or had any incidences of ownership in;
(2)    Property in which the decedent retained a life estate;
(3)    Certain transfers made within three years of death;
(4)    Transfers effective at death;
(5)    Annuities; 
(6)    Pension assets (including IRA's); and
(7)    Property over which the decedent had a general power of appointment at the time of death.

Once the gross estate is determined, certain deductions are permitted.  The most common deductions are for transfers to the decedent's spouse (see Marital Deduction, below), transfers to charity (see Charitable Deduction, below), the decedent's debts, funeral and burial expenses, and the expenses of administering the estate (attorney and accountant fees, executor fees, etc.).  The gross estate minus these deductions is known as the "taxable estate."

If the decedent made taxable gifts during life, these gifts are added back to the estate before calculating the tax (this is one way in which the estate and gift transfer tax systems are unified).  The estate tax is calculated on this total amount, using a graduated tax schedule which starts at a rate of 18% for estates below $10,000, and quickly rises to a rate of 55% on estates in excess of $3 million (and even higher for estates over $10 million).  The same tax rate applies to gifts (another unifying feature of estate and gift taxation).

Once the estate tax is calculated, certain credits are allowed.  Each individual is allowed a unified credit which can be applied to transfers made both during life and at death (again, unification of the tax systems).  In 2000, the unified credit is $220,550 (which effectively means that estates of $675,000 or less are not subject to estate tax).  A credit is also allowed for state death taxes paid, but subject to a limit depending on the size of the estate (see the Vermont Estate Tax System, below).  A credit is also allowed  for foreign death taxes.  Finally, a credit is allowed for taxes paid on gifts which were added back to the estate before calculating the estate tax (the last step in unification).

The Vermont Estate Tax System

Vermont's tax "system" is similar to the one in many other states.  Under this system, Vermont imposes an estate tax equal to the maximum state death tax credit allowed under federal law.  Known as a "sponge" or "sop-up" tax, this tax is designed to maximize the amount paid to Vermont without exceeding the amount for which a credit is allowed in determining the federal estate tax liability.  As a result, this type of state estate taxation does not increase the overall tax burden -- it simply shifts some of the tax from the federal to the state (Vermont) government.

A Sample Estate Tax Calculation

In order to illustrate the application of the transfer tax systems discussed above, consider the following example:

John Smith, a widower and Vermont resident, died on March 1, 2000 owning assets valued on that date as follows:
 

House	$   225,000
Vacation Home	$     90,000
Stocks & Bonds	$   280,000
Life Insurance	$   300,000 (proceeds)
IRA	$   450,000
Cash	$     40,000
Personal property/boat	$     80,000
Total estate	$1,465,000

The decedent had a mortgage of $125,000 on his home, and credit card debt of $10,000.  Funeral and burial costs were $8,000.  Attorney and accountant fees totaled $6,000.  The executor charged $2,000 to administer the estate.  The decedent made no taxable gifts during his lifetime.

From the gross estate, the debts of $135,000 (mortgage & credit cards) are subtracted, as are all of the expenses of administering the estate ($16,000) to arrive at a taxable estate of $1,314,000.  The tax on an estate of this size is $475,820 -- the estate is in the 43% marginal estate tax bracket.

Against this tax is allowed the unified credit of $220,500.  The credit for state death taxes to be paid to Vermont is also allowed.  This credit is determined according to a rate table set forth in the Internal Revenue Code.   For historical reasons, the estate is reduced by $60,000 prior to applying the rate table.  The result is a Vermont tax of $52,496.  The resulting federal estate tax is therefore $475,820 - $220,500 - $52,496 = $202,824.

The Vermont estate tax is simply the federal tax credit determined above -- $52,496.  The total federal and Vermont tax bill is $255,320, or about 19% of the taxable estate.

The Marital Deduction - QTIPs

For a married person, a major estate tax benefit is the ability to transfer assets to his or her spouse free of estate (or gift) taxation.  Any property transferred to a spouse, whether during life or at death, is deductible from the gross estate prior to the calculation of the estate tax.  This deduction is often the principal focus of estate plans involving married couples. 

"QTIP" is an acronym for "qualified terminable interest property."  A QTIP is a special type of transfer from one spouse to another that allows the transferring spouse to attach strings to the transfer while still preserving the marital deduction.  A transfer will qualify as a QTIP if, at a minimum, the spouse receiving the property receives all of the income from the property during his or her life.  This permits the transferring spouse to direct how the property (the principal) will ultimately be disposed of.  For example, a husband can transfer property to his wife, and provide that she will receive the income for her life, with the property passing to their children at the wife's death -- this transfer will qualify for QTIP treatment, and the marital deduction for estate tax purposes.

In most cases, a living trust is used to make a QTIP transfer.  In the above example, the trust could further authorize the trustee to make distributions of principal to the wife, if needed.  The wife could also be given a limited (or unlimited) right to withdraw principal.  Therefore, a QTIP can be molded to fit almost any estate planning need while maintaining the estate tax benefit of the marital deduction.

At the death of the surviving spouse, any QTIP assets held for his or her benefit are included in the surviving spouse's estate and subject to tax.

A Typical Estate Plan - A Married Couple

Under federal estate tax law, each individual can shelter (in 2000) $675,000 of assets from estate tax through use of the unified credit.  For a married couple, the ability to shelter from tax is doubled to $1,350,000 if the proper plan is implemented.

Since the marital deduction is unlimited, you might wonder why all of the assets are not simply left to the surviving spouse upon the death of the first spouse.  This would produce a zero estate tax, since the value of all of the assets would be deductible (the taxable estate would be zero).  Remember, however, that both spouses have the ability to shelter $675,000 in assets.  If all of the property passes to the surviving spouse, the ability of the first spouse to shelter assets would be wasted.  For example, if each spouse had $1 million in assets, and one spouse died leaving all of his or her assets to the survivor, the survivor would now have an estate of $2 million.  On the death of the survivor, only $675,000 could be sheltered, leaving $1,325,000 exposed to tax.  If on the death of the first spouse, his or her unified credit was utilized, then $1,350,000 could be sheltered, leaving "only" $650,000 subject to tax.  By utilizing both credits, a married couple can save their heirs over $200,000 in unnecessary estate taxes.

Here's how these tax savings can be accomplished.  If both spouses establish revocable (living) trusts (see the  Living (Revocable) Trusts webpage), when the first spouse dies, his or her assets can be divided into two separate trusts.  The first trust, commonly known as a "credit shelter trust" is funded in an amount equal to the unified credit available in the year of death.  The second trust, commonly known as a "marital deduction trust" is funded with the remainder of the decedent's assets.

The credit shelter trust is designed to provide income and possibly principal to the surviving spouse, but to create enough of a barrier so that on the surviving spouse's death, the trust assets will pass to the couple's heirs free of estate tax.  The surviving spouse can be given unlimited access to the credit shelter trust income, as well as limited access to the trust principal, without jeopardizing the estate tax benefits.   This is the mechanism by which the credit of the spouse, who dies first, is utilized.

The marital deduction trust can be a QTIP trust or a more (but not less) liberal trust arrangement.  In fact, the marital deduction trust does not have to be a trust at all -- the assets can be distributed to the surviving spouse with no restrictions. 

By joining the marital deduction with unified credit, a married couple can maximize the tax shelters provided under federal tax law, and thereby maximize the assets which pass to their heirs. 

The Charitable Deduction

Another method for reducing estate taxes is through the use of a charitable deduction.  The value of property which is left to a charity through a decedent's Will, trust or otherwise, is deductible from the decedent's gross estate.  Gifts to charities can be outright, or can be made by utilizing a charitable trust (see the Charitable Trusts webpage). 

Keep in mind that a deduction is allowed only for gifts made to a "charity" -- a term which has a very specific meaning under the Internal Revenue Code.  Some organizations which are not-for-profit may not qualify as a charity for estate tax purposes.  You should therefore check the status of any organization named in your estate plan if the resulting charitable deduction is part of your planning.  Similarly, your estate plan should provide for one or more alternate charitable beneficiaries in case your primary beneficiary ceases to exist or loses its status as a charity. 

Generation Skipping Transfer Taxation

As if the taxes discussed above are not enough, the federal system imposes yet another tax on transfers which "skip" a generation.  The theory of the generation skipping transfer tax (or "GST") is that if (for example) a grandparent transfers assets to a grandchild (known as a "skip person"), the estate tax that would have been imposed on the middle generation (i.e. the grandparent's child) is lost.  To recoup this tax, the GST is imposed on any transfer (not necessarily from grandparent to grandchild) which skips a generation.  The GST is imposed at the highest marginal estate tax rate (55%), and is in addition to the estate tax levied on the same transfer.  Where both taxes apply, the resulting tax can exceed 80%.

Some relief is afforded under the GST rules.  First, each individual is permitted to transfer up to $1 million to "skip" persons without the imposition of the GST.  Therefore, the GST affects only larger estates.  Second, during life, an individual can gift up to $10,000 per year/per skip person without incurring GST (see the Lifetime Gifts webpage)

To put it mildly, GST planning is very complicated.  There are many rules governing the use of trusts, the assignment of generational levels, the application of the $1 million exemption, etc. which make the GST one of the most difficult areas of tax law.