Estates and Gifts

Please read this chapter, attached, and post the importance issues for this area:

Why do you need a will – who has one?
What is the difference between gift and estate planning.
Why is planning so important?
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Learning Objectives
Upon completing this chapter, you should be able to:
1. LO 14-1Outline the basic structure of federal transfer taxes and describe the valuation of property
transfers.
2. LO 14-2Summarize the operation of the federal gift tax and the calculation of the federal gift tax.
3. LO 14-3Describe the federal estate tax, and compute taxable transfers at death and the federal estate tax.
4. LO 14-4Apply fundamental principles of wealth planning and explain how income and transfer taxation
interact to affect wealth planning.
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© Michal Kowalski/Shutterstock.com
Storyline Summary
Taxpayers: Bob and Harry Smith, brothers, ages 69 and 63, respectively.
Frank’s Frozen Pizza Inc. (FFP) is a family business.
Description: Bob, recently deceased, was a widower and has a son, Nate (age 28). Harry is married to Wilma,
age 38, and has a daughter, Dina (age 35), a son-in-law, Steve, and a grandson, George (age 6).
Location: Ann Arbor, Michigan
Employment
status:
Bob and Harry inherited shares in FFP in 1990.
Bob and Harry have been employees of FFP.
Bob retired from FFP and died earlier this year.
Harry is planning to retire as CEO of FFP.
Current
situation:
Nate is Bob’s executor.7/6/2017 IEB Wireframe
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H ar
ry and Bob Smith were brothers and owners of a small privately held corporation, Frank’s Frozen Pizzas Inc.
(FFP). Their father, Frank, established the business 35 years ago, and Harry and Bob each inherited half of FFP’s
outstanding shares upon Frank’s death. At the time of Frank’s death in 1990, FFP shares were worth about $1
million, but the firm is now debt-free and has a value of $9 million. FFP’s success didn’t come easy. Over the
years Harry and Bob were employed as executive officers and worked long, hard hours. After the death of his
wife in 1995, Bob retired on his FFP pension. Over the years both Harry and Bob have transferred some of their
FFP shares to other family members. Bob has given 20 percent of the shares in FFP to his son, Nate, and Harry
has transferred a like amount to a trust established for Dina (his daughter) and George (his grandson).
Harry recently decided that he wants to retire from FFP and spend more time traveling and enjoying his family.
Harry believes that Nate would like to assume responsibilities as CEO, and Dina has agreed to support Nate’s
decisions. Harry plans to begin an orderly transfer of his FFP stock to Dina to provide a future source of support
for her and George. Besides his FFP stock, Harry has accumulated considerable personal assets to help maintain
his lifestyle during retirement. Although Wilma, Harry’s wife, owns significant assets, Harry also wants to
provide for her support after his death. Finally, while Harry believes taxes and lawyers are necessary evils, he
wants to avoid any unnecessary fees or taxes associated with the transfer of his assets. Hence, Harry would like
advice on how to make his gifts in the most tax-efficient manner.
Early this year Bob was injured in an auto accident. Unable to recover from his injuries, he died after two days
in the hospital. Bob is survived by his son, Nate, who is also the executor of Bob’s estate. Nate is now collecting
his father’s assets, and he would like help in preparing Bob’s federal estate tax return.

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INTRODUCTION TO FEDERAL TRANSFER TAXES
LO 14-1
This chapter explains the structure of the federal transfer taxes. We begin by outlining transfer taxes and then
proceed to describing in detail the federal gift tax. Finally, we describe the federal estate tax and introduce the
principles of wealth planning.
Beginnings
In 1916 Congress imposed an estate tax on transfers of property at death. Transfers at death are dictated by the
last will and testament of the deceased and such transfers are called testamentary transfers. The transfer tax
system was expanded in 1924 to include a gift tax on lifetime transfers called intervivos transfers (from the
Latin meaning “during the life of”). Eventually, a generation-skipping tax was also added to prevent tax
avoidance by transferring assets to younger generations (transfers to grandchildren rather than to children).1
Together, this trio of taxes represents one way of reducing the potential wealth society’s richest families might
accumulate over several generations. (Remember, neither gifts nor inheritances are included in recipients’ gross
income.)
TAXES IN THE REAL WORLD Perfect Timing
Roger Milliken died on December 30, 2010, just two days before the estate tax was revived. Milliken was 95
years old and had directed his family’s business for 71 years as president and CEO of Milliken & Company.
Milliken’s estate, estimated under $1 billion, was subject to probate in Spartanburg County, South Carolina. In
his 111-page will, described by the Spartanburg Journal Watchdog, Milliken established multiple trusts and
directed that the family business would remain privately owned. Moreover, Milliken instructed trustees that no
change of tax laws would warrant deviating from his intentions. In a two-page letter, Milliken expressed the
hope that income from the trust would enable his descendants to pursue careers. To qualify for income from the
trusts, Milliken’s children must be 40 years old at which time they will be eligible to receive 10 percent of the
trust’s income. The distribution increases to 50 percent at age 44 and to all of the net income by the age of 49.
Milliken also expressed hope that money from the trusts would enable his children and grandchildren to achieve
true self-fulfillment and happiness.
Common Features of Integrated Transfer Taxes
The two primary federal transfer taxes, the gift tax and the estate tax, were originally enacted separately and
operated independently. In 1976 they were unified into a transfer tax scheme that applies a progressive tax rate
schedule to cumulative transfers. In other words, the gift and estate taxes now are integrated into a common
formula.
This integrated formula takes into account the cumulative effect of transfers in previous periods when
calculating the tax on a (gift) transfer in a current period. Likewise, it takes lifetime transfers into account to
determine the tax on assets transferred at death. As you’ll see in the tax formulas, we add the taxable transfers in
prior years to the current-year transfers and compute the tax on total (cumulative) transfers. Then, we subtract
the tax on the prior-year transfers from the total tax, to avoid taxing them twice. This calculation ensures that the
current transfers will be taxed at a marginal tax rate as high or higher than the rate applicable to the prior-year
transfers. Exhibit 14-1 presents the unified transfer tax rate schedule for estate and gift taxes that has been in
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EXHIBIT 14-1
EXHIBIT 14-1Unified Transfer Tax Rates*
The second common feature of the integrated transfer taxes is the applicable credit. This credit, also known as
the unified credit, was enacted in 1977, and it applies to both the gift tax and the estate tax. The credit is
designed to prevent the application of transfer tax to taxpayers who either would not accumulate a relatively
large amount of property transfers during their lifetime and/or would not have a relatively large transfer passing
to heirs upon their death. The amount of cumulative taxable transfers a person can make without exceeding the
unified credit is called the exemption equivalent or, alternatively, the applicable exclusion amount.
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THE KEY FACTS
Common Features of the Unified Transfer Taxes
Property transfers, whether made by gift or at death, are subject to transfer tax using a progressive tax rate
schedule.
The unified credit exempts cumulative transfers of up to $5.45 million ($10.9 million for married
taxpayers).
Each transfer tax allows a deduction for transfers to charities and surviving spouses (the charitable and
marital deductions, respectively).
Exhibit 14-2 presents the exemption equivalent amounts for both the estate and gift taxes since 1986. The
exemption equivalent was the same amount for gift and estate tax purposes until 2004, at which time the gift tax
was frozen at $1,000,000 exemption equivalent. In 2011, the exemption equivalent for the gift tax was reunified
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EXHIBIT 14-2
EXHIBIT 14-2The Exemption Equivalent
The amount of the unified credit depends on both the transfer tax rates and the exemption equivalent that apply
in the year of the transfer. Because both the tax rates and the exemption equivalent can change over time, the
unified credit is best calculated by tracking the exemption equivalent and converting it into the unified tax credit
using the current tax rate schedule. For example, the exemption equivalent was $5 million for transfers made in
2011. Consequently, when evaluating a 2011 (or prior-year) transfer for purposes of determining the current-year
gift tax, the unified credit for 2011 will be $1,945,800 (no matter what the actual rates were in 2011). In contrast,
the exemption equivalent is $5.45 million for transfers made in 2016 and under the current unified tax rate
schedule the unified credit is $2,125,800.
Page 14-4
A third common feature of the unified tax system is the application of two common deductions. Each transfer
tax provides an unlimited charitable deduction for charitable contributions and a generous marital deduction
for transfers to a spouse. The marital deduction allows almost unfettered transfers between spouses, treating a
married couple as virtually a single taxpayer.
A final important feature of the transfer taxes is the valuation of transferred property. Property transferred via
gift or otherwise is valued at fair market value. While fair market value is simple in concept, it is very
complicated to apply. For purposes of the transfer taxes, fair market value is defined by the willing-buyer,
willing-seller rule as follows:
The price at which such property would change hands between a willing buyer and a willing seller, neither being
under any compulsion to buy or to sell, and both have reasonable knowledge of the relevant facts.
Fair market value is determined based on the facts and circumstances for each individual property. Determining
value is relatively simple for properties that have an active market. For example, stocks and bonds traded on
exchanges or over the counter are valued at the mean of the highest and lowest selling prices. Unfortunately, the
valuation of many other properties, especially realty, is very difficult. The large number of court cases resolving
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1The estate tax was optional for decedents dying in 2010. In lieu of the estate tax, executors could opt to have
the adjusted tax basis of the assets in gross estate carry over to the heirs of the decedent. The estate tax is back in
place for decedents dying subsequent to 2010.

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THE FEDERAL GIFT TAX
LO 14-2
The gift tax is levied on individual taxpayers for all taxable gifts made during a calendar year. As explained
shortly, each individual (married couples cannot elect joint filing for gift tax returns) who makes a gift in excess
of the annual exclusion amount must file a gift tax return (Form 709) by April 15 of the following year.2 Exhibit
14-3 presents the complete formula for the federal gift tax in two parts. In the first part, taxable gifts are
calculated for each donee, and in the second, the gift tax is calculated using aggregate taxable gifts to all donees.
We begin the first part by identifying transfers that constitute gifts.
EXHIBIT 14-3
EXHIBIT 14-3The Federal Gift Tax Formula
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Transfers Subject to Gift Tax
The gift tax is imposed on lifetime transfers of property for less than adequate consideration. Typically, a gift is
made in a personal context such as between family members. The satisfaction of an obligation is not considered
a gift. For example, tuition payments for a child’s education satisfy a support obligation. On the other hand,
transfers motivated by affection or other personal motives, including transfers associated with marriage, are
gratuitous and subject to the tax. The gift tax is imposed once a gift has been completed, and this occurs when
the donor relinquishes control of the property and the donee accepts the gift.3 For example, deposits made to a
joint bank account are not completed gifts because the donor (depositor) can withdraw the deposit at any time.
The gift will be complete at the time the donee withdraws cash from the account.
THE KEY FACTS
Gifts Excluded from the Gift Tax
Incomplete and revocable gifts.
Payments for support obligations or debts.
Contributions to political parties or candidates.
Medical and educational expenses paid on behalf of an unrelated individual.
TAXES IN THE REAL WORLD Love and Taxes7/6/2017 IEB Wireframe
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The small claims division of the Tax Court was asked to determine whether payments between former lovers
constituted gifts or compensation. Jue-Ya Yang lived with her boyfriend, Howard Shih, who was an artist and
calligrapher. While they were romantically involved, Mr. Shih made payments to Ms. Yang and later deducted
these payments as wages.
Ms. Yang admitted doing housekeeping and cooking, but she argued that the payments were gifts. Mr. Shih’s
testimony about the romantic relationship was evasive. He admitted on cross-examination that while their
relationship was more than a professional one, Mr. Shih could not even recall taking Ms. Yang out on dates. The
court concluded that Mr. Shih’s testimony was untrue and held that the payments were gifts made because of
love and affection.
Source: Jue-Ya Yang, TC Summary Opinion 2008-156 (12-15-08).
In some instances a donor may relinquish some control over transferred property but retain other powers that can
influence the enjoyment or disposition of the property. If the retained powers are important, then the transfer will
not be a complete gift.4 For example, a transfer of property to a trust will not be a complete gift if the grantor
retains the ability to revoke the transfer. If the grantor releases the powers, then the gift will generally be
complete at that time because the property is no longer subject to the donor’s control. For example, a distribution
of property from a revocable trust is a completed gift because the grantor no longer has the ability to revoke the
distribution.
Example 14-1
On July 12th of this year Harry transferred $250,000 of FFP stock to a new trust. He gave the trustee directions
to pay income to Dina for the next 20 years and then remit the remainder to her son George. Harry named a bank
as trustee but retained the power to revoke the trust in case he should need additional assets after retirement. Is
the transfer of the stock a completed gift?
Answer: No. Harry retains sufficient control that the transfer of the stock to the trust is an incomplete gift.
What if: Suppose that $15,000 of trust income were distributed to Dina at year-end. Is the transfer of the cash to
Dina a completed gift?
Answer: Yes. With the payment Harry has relinquished control over the $15,000, and thus, it is a completed gift.
What if: Suppose that Harry releases his power to revoke the trust at a time when the shares of FPP in the trust
are valued at $225,000. Would this release cause the transfer of the stock to be a completed gift and, if so, what
is the amount of the gift?
Answer: Yes. By releasing his powers Harry has relinquished control over the entire trust, and the value of the
trust at that time ($225,000) would be a completed gift.
Page 14-6
There are several important exceptions to the taxation of completed gifts. For example, political contributions
are not gifts. Also, the payment of medical or educational expenses on behalf of another individual is not
considered a gift if the payments are made directly to the health care provider or to the educational institution.
To avoid confusing a division of property with a gift, a transfer of property in conjunction with a divorce is
treated as nongratuitous (it is treated as a transfer for adequate consideration) if the property is transferred within
three years of the divorce under a written property settlement.
In addition, special rules apply to transfers of certain types of property. To make a completed gift of a life
insurance policy, the donor must give the donee all the incidents of ownership, including the power to designate
beneficiaries. An individual who creates a joint tenancy (either a tenancy in common or joint tenancy with right
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The gift is the amount necessary to pay for the other party’s interest in the property. For example, suppose the
donor pays $80,000 toward the purchase of $100,000 in realty held as equal tenants in common with the donee
(i.e., the donee provides only $20,000 of the purchase). The donor is deemed to make a gift of $30,000 to the
donee, the difference between the value of the joint interest ($100,000 ÷ 2 = $50,000) and the consideration
provided by the donee ($20,000).
ETHICS
Rudy is a retired engineer who has three adult daughters and several grandchildren. This year Carol, his
youngest daughter, approached Rudy for a $40,000 business loan. Although Carol had no collateral for the loan
and did not sign any written promise to repay the money, Rudy still transferred the funds to her account. Do you
think that Rudy should file a gift tax return for the transfer? Suppose that Rudy has no intention of demanding
repayment, but has not told anyone of his intention. Any difference?
Example 14-2
This year Harry helped purchase a residence for use by Dina and her husband Steve. The price of the residence
was $250,000, and the title named Harry and Steve joint tenants with the right of survivorship. Harry provided
$210,000 of the purchase price and Steve the remaining $40,000. Has Harry made a completed gift and, if so, in
what amount?
Answer: Yes, Harry made a complete gift to Steve of $85,000, calculated by subtracting the amount paid by
Steve from the price of his ownership interest ($125,000 minus $40,000).
What if: Suppose Steve didn’t provide any part of the purchase price. What is the amount of the gift?
Answer: Harry made a complete gift to Steve of half the purchase price, $125,000.
ValuationGifts are taxed at the fair market value of the donated property on the date the gift becomes complete.
Remember, that despite the valuation of a gift at fair market value, the donee generally takes a carryover basis
for income tax purposes.5
Valuation of remainders and other temporal interests.Assigning value to unique property is difficult enough, but
sometimes we must also assign a value to a stream of payments over time or a payment to be made in the future.
The right to currently enjoy property or receive income payments from property is called a present interest. In
contrast, the right to receive income or property in the future is called a future interest. A present right to
possess and/or collect income from property may not be permanent; if granted for a specific period of time or
until the occurrence of a specific event, it is a terminable interest. For example, the right to receive income
payments from property for 10 years is a terminable interest. A right to possess property and/or receive income
for the duration of someone’s life is called a life estate. The person whose life determines the duration of the life
estate is called the life tenant.
Page 14-7
At the end of a terminable interest, the property will pass to another owner, the person holding the future
interest. In a reversion, it returns to the original owner. If it goes to a new owner, the right to the property is
called a remainder and the owner is called a remainderman. For example, the right to own property after a 10-
year income interest has ended is a future interest held by the remainderman. The right to property after the
termination of a life estate is also called a remainder.
Future interests are common when property is placed in a trust. Trusts are legal entities established by a person
called the grantor. Trusts are administered by a trustee and generally contain property called the trust corpus.
The trustee has a fiduciary duty to manage the property in the trust for the benefit of a beneficiary or
beneficiaries. This duty requires the trustee to administer the trust in an objective and impartial manner and not
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Since a future interest is essentially a promise of a future payment, we estimate the value of the remainder by
discounting the future payment to a present value using a market rate of interest. For example, suppose property
worth $100 is placed in a trust with the income to be paid to an income beneficiary each year for 10 years, after
which time the property accumulated in the trust will be distributed. The remainder is a future interest with a
value we estimate by calculating the present value of a payment of $100 in 10 years as follows:
where r is the market rate of interest, and n is the number of years. The interest rate used for this calculation is
published monthly by the Treasury as the §7520 rate.6 If the §7520 rate is 6 percent, we calculate the value of a
remainder of $100 placed in trust for 10 years as follows:
The value of property consists of the present interest (the right to income) and the future interest (the remainder).
Hence, once we have estimated the value of the remainder, we compute the value of the income interest as the
difference between the value of the remainder and the total value of the property.
THE KEY FACTS
Valuation of Remainders and Income Interests
Future interests are valued at present value, calculated by estimating the time until the present interest
expires.
The present value calculation uses the §7520 interest rate published by the Treasury.
If the present interest is measured by a person’s life (a life estate), then we estimate the delay by reference
to the person’s life expectancy as published in IRS tables.
We value a present interest such as an income interest or life estate by subtracting the value of the
remainder interest from the total value of the property.
If the terminable interest is a life estate, the valuation of the remainder is a bit more complicated, because
payment of the remainder is delayed by the duration of the life estate. To estimate this delay, we base the
calculation upon the number of years the life tenant is expected to live. To facilitate the calculation, the
regulations provide a table that calculates the discount rate by including the life tenant’s age. Exhibit 14-4
includes a portion of the table from the regulation with interest rates by column and the age of the life tenant by
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EXHIBIT 14-4
EXHIBIT 14-4Discount Factors for Estimating the Value of Remainders
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Example 14-3
Harry transferred $500,000 of FFP stock to the DG Trust, whose trustee is directed to pay income to Dina for
her life and, upon Dina’s death, pay the remainder to George (or his estate). At time of the gift, Dina was 35
years old and the §7520 interest rate was 5.8 percent. What are the values of the gift of the life estate and of the
remainder interest?
Answer: Harry made a $59,460 gift of the remainder to George and $440,540 of the life estate to Dina. Under
Table S (see Exhibit 14-4), the percentage of the property that represents the value of George’s remainder is
0.11892. Thus, George’s remainder is valued at $59,460 ($500,000 × 0.11892). Dina’s life estate is the remaining
value of $440,540 ($500,000 − $59,460).
The Annual ExclusionOne of the most important aspects of the gift tax is the annual exclusion, which operates
to eliminate “small” gifts from the gift tax base. The amount of the exclusion has been revised upwards
periodically over the years and is now indexed for inflation.7 In 2016 it is $14,000.
The annual exclusion is available to offset gifts made to each donee regardless of the number of donees in any
particular year. For example, a donor could give $14,000 in cash to each of 10 donees every year without
exceeding the annual exclusion. One important limitation to the annual exclusion is that it applies only to gifts of
present interests; that is, a gift of a future interest is not eligible for an annual exclusion.
Page 14-9
Example 14-4
When Harry transferred $500,000 of FFP stock to the DG Trust (Example 14-3), he simultaneously made two
taxable gifts, a life estate to Dina and a remainder to George. What is the amount of the taxable gift of the life
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Answer: Dina’s life estate is a present interest and would qualify for the annual exclusion. However, George’s
remainder is a future interest and will not qualify for the annual exclusion. Harry would file a Form 709 to report
total taxable gifts of $486,000 consisting of a $426,540 taxable gift to Dina ($440,540 less the annual exclusion
of $14,000) and a taxable gift of $59,460 to George (no annual exclusion is available for a future interest).
THE KEY FACTS
Annual Exclusion
Most gifts are eligible for an annual exclusion of $14,000 per donee per year.
Gifts of present interests qualify for the exclusion.
Gifts of future interests placed in trust for a minor can also qualify for the exclusion.
Most gifts will only qualify for an annual exclusion if the donee has a present interest (the ability to immediately
use the property or the income from it). However, a special exception applies to future interests given to minors
(under the age of 21). Gifts in trust for a minor are future interests if the minor does not have the ability to
access the income or property until reaching the age of majority. These gifts will still qualify for the annual
exclusion as long as the property can be used to support the minor and any remaining property is distributed to
the child once he or she reaches age 21.8
Example 14-5
Harry transferred $48,500 of cash to the George Trust. The trustee of the George Trust has the discretion to
distribute income or corpus (principal) for George’s benefit and is required to distribute all assets to George (or
his estate) not later than George’s 21st birthday. Is this gift eligible for the annual exclusion? If so, what is the
amount of the taxable gift?
Answer: Yes, Harry will be entitled to an annual exclusion for the transfer despite the fact that George’s interest
is a future one, because the gift is in trust for the support of a minor and the property must distribute the assets to
George once he reaches age 21. The amount of the gift is $48,500 reduced to a taxable gift of $34,500 after
application of the $14,000 annual exclusion.
Taxable Gifts
In part 1 of the formula in Exhibit 14-3, current gifts are accumulated for each donee, and this amount includes
all gifts completed during the calendar year for each individual. Current gifts do not include transfers exempted
from the tax, such as political contributions. Several adjustments are made to calculate current taxable gifts for
each donee. As we’ve seen, each taxpayer is allowed an annual exclusion applied to the cumulative gifts of
present interests made during the year to each donee. Next, if a married couple elects to split gifts (discussed
below), half of each gift is included in current gifts of each spouse. The marital deduction for gifts to spouses
and the charitable deduction for gifts to charity are the last adjustments to calculate taxable gifts for each donee.
We discuss each in turn.
Page 14-10
Gift-Splitting ElectionMarried couples have the option to split gifts, allowing them to treat all gifts made in a
year as if each spouse had made one-half of each gift. In a community property state, both spouses
automatically own equal shares in most property acquired during the marriage.9 Hence, when they make a gift
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own a disproportionate amount of property because he or she earns most of the income. The gift-splitting
election provides a mechanism for married couples in common-law states to achieve the same result as couples
receive automatically in community property states.10
Example 14-6
Wilma and Harry live in Michigan, a common-law state. For the holidays Wilma gave cash gifts of $30,000 to
Steve and $41,000 to Dina. Wilma and Harry did not elect to split gifts. What is the amount of Wilma’s taxable
gifts?
Answer: $43,000. After using her annual exclusion (both gifts are present interests), Wilma has made taxable
gifts of $16,000 to Steve ($30,000 − $14,000) and $27,000 to Dina ($41,000 − $14,000).
What if: Suppose Wilma and Harry elect gift-splitting this year. How would your answer change?
Answer: Both Wilma and Harry made taxable gifts of $7,500. Under gift-splitting, Wilma and Harry are each
treated as making a gift of $15,000 to Steve and $20,500 to Dina. After the annual exclusion, both Wilma and
Harry made a $1,000 taxable gift to Steve [($30,000 ÷ 2) − $14,000 = $1,000]. In addition, both Wilma and
Harry made a $6,500 taxable gift to Dina [($41,000 ÷ 2) − $14,000 = $6,500].
What if: Suppose Wilma and Harry lived in Texas (a community property state), and Wilma made the same gifts
from community property.
Answer: Both Wilma and Harry made a taxable gift of $7,500. Under state law, each spouse is automatically
treated as gifting half the value of any gifts made from community property. After the annual exclusion, both
Wilma and Harry made a $1,000 taxable gift to Steve [($30,000 ÷ 2) − $14,000], and each made a $6,500
taxable gift to Dina [($41,000 ÷ 2) − $14,000].
Besides increasing the application of the annual exclusion, a gift-splitting election also increases the likelihood
that taxable gifts will be taxed at lower tax rates or any gift tax will be offset by unified credits. To utilize giftsplitting, each spouse must be a citizen or resident of the United States, be married at the time of the gift, and not
remarry during the remainder of the calendar year. Both spouses must consent to the election by filing a timely
gift tax return. Taxpayers make this election annually and can apply it to all gifts completed by either spouse
during the calendar year. As a result of the election, both spouses share a joint and several liability for any gift
tax due.
Marital DeductionThe marital deduction was originally enacted to equalize the treatment of spouses residing in
common-law states. In community property states, the ownership of most property acquired during a marriage is
automatically divided between the spouses. In common-law states, one spouse can own a disproportionate
amount of property if he or she earns most of the income. Absent the marital deduction, in a common-law state,
a transfer between the spouses to equalize the ownership of property would be treated as a taxable gift.
However, because transfers to spouses are eligible for a marital deduction, no taxable gift results from such a
transfer.
THE KEY FACTS
Marital Deduction
Deduct gifts of property to a spouse in computing taxable gifts.
Transfers of terminable interests in property, such as a life estate, will not generally qualify for the
deduction.
The deduction is limited to the value of property included in taxable gifts.
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The marital deduction is subject to two limits. First, the amount is limited to the value of the gift after the annual
exclusion. Second, transfers of nondeductible terminable interests do not qualify for a marital deduction. A
nondeductible terminable interest is a property interest transferred to the spouse that terminates when some
event occurs or after a specified amount of time, when the property is transferred to another.
Example 14-7
After his decision to retire, Harry gave Wilma a piece of jewelry that is a family heirloom valued at $50,000.
What is the amount of this taxable gift?
Answer: Zero. This gift will qualify for an annual exclusion, and the value after subtracting the annual exclusion
qualifies for the marital deduction. The taxable gift is calculated below:
What if: Suppose Harry transferred $200,000 to a trust with directions to pay income to Wilma for her life (a life
estate). After Wilma’s death, the corpus of the trust would then pass to Dina (the remainder). What is the amount
of this taxable gift if Wilma is age 38 at the time and the §7520 interest rate is 5 percent?
Answer: The total taxable gift is $186,000. This transfer is actually two gifts, a gift of a present interest to
Wilma (a life estate) and a future interest to Dina (the remainder). The gift of the remainder is valued at $34,340
using Wilma’s age and the §7520 interest rate from the table in Exhibit 14-4 ($200,000 × 0.17170). The
remainder does not qualify for an annual exclusion because it is a future interest. The gift of the life estate is a
present interest valued at $165,660 ($200,000 − $34,340), and it qualifies for the annual exclusion. The taxable
gifts are calculated below:
When the life estate is given to a spouse, it does not qualify for the marital deduction because it will terminate
upon a future event (Wilma’s death) and then pass to another person (Dina).
The limitation on the deductibility of terminable interests ensures that property owned by a married couple is
subject to a transfer tax when the property is eventually transferred from the couple (as opposed to between the
spouses).11 If a life estate were eligible for a marital deduction, it would not be taxed at the time of the gift nor
would any value be taxed upon Wilma’s death (the life estate disappears with her death). Hence, a marital
deduction is available only for spousal transfers that will eventually be included in the recipient spouse’s
estate.12
Page 14-12
Charitable DeductionThe amount of the charitable deduction is also limited to the value of the gift after the
annual exclusion. Requirements for an organization to qualify for the gift tax charitable deduction are quite
similar to those for the income tax deduction (the entity must be organized for religious, charitable, scientific,
educational, or other public purposes, including governmental entities). Unlike the income tax deduction,
however, the charitable deduction has no percentage limitation. In addition, as long as the qualifying charity
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other taxable gifts). Finally, a transfer to a charity also qualifies for an income tax deduction (subject to the AGI
limits on the income tax charitable deduction).
Example 14-8
Harry donated $155,000 in cash to State University. What is the amount of the taxable gift?
Answer: Zero. The gift qualifies for the charitable gift tax deduction, as calculated below.
Note that Harry can also claim an income tax deduction for the transfer.
Computation of the Gift Tax
Part 2 of the formula in Exhibit 14-3 provides the method of calculating the gift tax. It begins by summing the
taxable gifts made for all donees during a calendar year.
Example 14-9
Harry and Wilma did not make any gifts from community property and did not elect to gift-split this year (see
Example 14-6). What is the amount of Harry’s current taxable gifts this year?
Answer: Harry made $591,500 of taxable gifts, calculated using Part 1 of the formula in Exhibit 14-3 as follows:
Page 14-13
The amounts of the marital and charitable deductions are limited to the value of the property included in taxable
gifts.
Will Wilma be required to file a gift tax return this year? If so, what is the amount of her taxable gifts?
Answer: Wilma must also file a gift tax return this year because her current gifts exceed the annual exclusion.
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What if: What is the amount of Harry and Wilma’s taxable gifts if they elect to gift-split?
Answer: Harry and Wilma each made $310,250 of taxable gifts, calculated as follows:
Note that absent gift-splitting, Harry and Wilma made taxable gifts totaling $634,500 ($591,500 + $43,000), but
under gift-splitting that reduced to $620,500 ($310,250 + $310,250) because Wilma was able to use an
additional $14,000 annual exclusion for her portion of the gift to the George Trust. Neither Harry nor Wilma was
able to use any additional annual exclusions for the gifts to Steve and Dina because they had already used annual
exclusions to these two donees. If they elect to gift-split, Harry and Wilma will be jointly and severally liable for
the gift taxes.
Tax on Current Taxable GiftsThe first step to computing the gift tax on current taxable gifts is to add prior
taxable gifts to current taxable gifts. The purpose of adding gifts from previous periods is to increase the tax
base and thereby increase the marginal tax rate applying to current gifts. To prevent double taxation of prior
taxable gifts, the gift tax on prior taxable gifts is subtracted from the tax on total transfers. Two elements of the
tax on prior taxable gifts are important to understand. First, the tax is calculated on prior taxable gifts ignoring
whether any unified credit was claimed on the gifts in the prior year. Second, the tax on prior taxable gifts is
computed using the current rate schedule (the tax rates for the year of the prior transfer are not relevant). The
difference between the tax on cumulative taxable gifts and prior taxable gifts is the tax on the current taxable
gifts.
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Unified CreditThe last adjustment in the formula is the unused portion of the unified credit. Recall that the
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change over time because it is indexed for inflation (for example, the exemption equivalent is 5.45 million for
2016, see Exhibit 14-2). Hence, rather than track the unused portion of the unified credit, it is far easier to track
the unused portion of the exemption equivalent and then convert that into the unified credit using current rates.
Tracking the unused portion of the exemption equivalent makes sense because the exemption equivalent is
ignored in calculating the tax on prior taxable gifts.
For example, suppose an individual transferred via gift $3 million in a prior year (when the exemption
equivalent was $1 million) and $6 million in the current year (when the exemption equivalent increased to $5
million). This individual made cumulative transfers of $9 million and is entitled to an exemption equivalent of
$5 million. Based on the gift tax formula, a transfer tax would be calculated on $9 million less the transfer tax on
the prior taxable gifts on $3 million. Thus, the current taxable transfer would be $6 million, and the tax on this
amount would be reduced by the tax on the unused exemption equivalent of $4 million ($5 million less $1
million used in a prior year). In sum, this individual would owe transfer tax on $2 million. This is a fair outcome
because in a prior year the individual paid tax on $2 million ($3 million less the $1 million exemption equivalent
in the prior year). Note that the exemption equivalent (converted into the unified credit at current rates)
eliminates the gift tax for individuals who do not transfer a relatively large cumulative amount of property
during their lifetime.
Also, note that a gift tax return must be filed by each individual (no joint filing) who has made taxable gifts
during the calendar year or who elects to split gifts, even if no tax is due because of the unified credit.
Example 14-10
Assume that Harry made a taxable gift of $1,500,000 in 2007. At that time, the exemption equivalent for the gift
tax was $1 million, so Harry paid gift taxes on $500,000. Harry has not made any taxable gifts since 2007. This
year, however, Harry made taxable gifts of $591,500. What is Harry’s gift tax and Harry’s unused exemption
equivalent (unified credit)?
Answer: Harry will report cumulative taxable gifts of $2,091,500, but he will not owe any gift tax due this year.
The calculation is as follows:
Page 14-15
Harry used $1 million of his exemption equivalent in 2007, and this year he used another $591,500. Hence, at
the end of 2016, Harry has $3,858,500 of unused exemption equivalent remaining ($5,450,000 − $1,000,000 −
$591,500), which translates into an unused unified credit of $1,489,200.
What if: Suppose that Harry made a taxable gift of $3,500,000 in 2007, and at that time, the exemption
equivalent was $1 million. What should Harry report this year as his cumulative taxable gifts, gift tax on
cumulative taxable gifts, gift tax on current taxable gifts, credit for current tax on prior taxable gifts, and gift tax
due?
Answer: Harry should report cumulative taxable gifts of $4,091,500 and gift tax on cumulative gifts of
$1,582,400. Harry, however, owes no gift tax. The calculation is as follows:7/6/2017 IEB Wireframe
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At the end of 2016, Harry would have $3,858,500 of exemption equivalent remaining ($5,450,000 − $1,000,000
− $591,500). Note that Harry probably paid gift tax in 2007 because his taxable gifts far exceeded the exemption
equivalent of $1 million in 2007. However, the amount of gift tax that was paid in 2007 is not relevant for
calculating Harry’s current tax. All calculations in the current year are made using the current tax rate schedule
(not the one that applied in prior years).
What is Wilma’s gift tax due?
Wilma has used $43,000 of her exemption equivalent. Hence, at the end of 2016, Wilma has $5,407,000 of
exemption equivalent remaining.
To reiterate, the gift tax requires donors to keep track of the portion of the exemption equivalent they used to
generate a unified credit to offset prior taxable gifts. This prevents multiple applications of the same exemption.
The gift tax on previous gifts is computed using the current tax rate schedule, but this amount does not represent
the amount of gift tax paid—just the gifts previously subject to tax. The unused portion of the applicable credit
then reduces the total gift tax to reach the gift tax due. The gift tax is calculated using the current rate schedule
and ignores the amount of gift tax actually paid in prior periods. Exhibit 14-5 presents the first page of the 2015
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EXHIBIT 14-5
EXHIBIT 14-5Page 1 of Form 709 Gift Tax Return for Harry Smith
2A gift tax return reporting taxable gifts must be filed by April 15th following year-end if a taxpayer has made
any taxable gifts during the current calendar year or wishes to elect gift-splitting. When taxpayers request
extensions for their individual income tax returns, they also receive a six-month extension for filing their gift tax
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3If a donee refuses or disclaims a gift under §2518, the gift is not complete.
4§2514 addresses the treatment of general powers of appointment.
5The carryover basis may be increased for any gift tax paid (after 1976) on the appreciation of the property.
6The §7520 rate is 120 percent of the applicable federal midterm rate in effect during the month of the
transaction.
7The exclusion is indexed for inflation in such a way that the amount of the exclusion only increases in
increments of $1,000. The annual exclusion was $10,000 from 1981 through 2001, but was $11,000 for 2002
through 2005, $12,000 for 2006 through 2008, $13,000 for 2009 through 2012, and $14,000 since 2012.
8The courts have created another exception to the present interest rule called Crummey power. A discussion of
this exception is beyond the scope of this text.
9Depending upon state law, the ownership of property acquired by either spouse prior to a marriage is not
automatically divided equally between the spouses. In other words, property owned prior to the marriage is not
necessarily community property and continues to belong to the original owner.
10There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico,
Texas, Washington, and Wisconsin.
11Qualified terminable interest properties (QTIPs for short) are an exception to the nondeductibility of
terminable interest property. A detailed discussion of this exception is beyond the scope of this text.
12The spouse must be entitled to all of the income from the property payable at least annually, and no person has
the power to appoint any part of the property to anyone other than the spouse until the death of the spouse.

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Page 14-17
THE FEDERAL ESTATE TAX
LO 14-3
The estate tax is designed to tax the value of property owned or controlled by an individual at death, the
decedent. Because federal gift and estate taxes are integrated, taxable gifts affect the tax base for the estate tax.
Exhibit 14-6 presents the estate tax formula.
EXHIBIT 14-6
EXHIBIT 14-6The Federal Estate Tax Formula
The Gross Estate
Property possessed by or owned (titled) by a decedent at the time of death is generally referred to as the probate
estate, because the transfer of this property is carried out by a probate court. Probate is the process of gathering
property possessed by or titled in the name of a decedent at the time of death, paying the debts of the decedent,
and transferring the ownership of any remaining property to the decedent’s heirs. Property in the probate estate
can include cash, stocks, jewelry, clothing, and realty owned by or titled in the name of the deceased at the time
of death.
The gross estate is broader than the probate estate. The gross estate consists of (1) the fair market value of
property possessed or owned by a decedent at death plus (2) the value of certain automatic property transfers
that take effect at death.13 Property transfers that take effect only at death are not in the probate estate because
the transfer takes place just as death occurs. Hence, the probate court does not need to affect a transfer. However,
as discussed below, property subject to certain types of automatic transfers is specifically included in the gross
estate because the automatic transfer is a substitute for a testamentary transfer.
Example 14-11
What if: Nate took an inventory of his father’s property in preparation for distributing assets according to Bob’s
will. Nate must report this preliminary inventory of personal and investment property to the probate court; it
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Page 14-18
What amount of this property is included in Bob’s gross estate?
Answer: Bob’s gross estate includes the value of all the above property, or $10,089,450, because he owned these
assets at his death (i.e. these assets are included on Bob’s probate estate).
What if: Suppose Bob was also entitled to a pension distribution of $15,000 but had not yet received the check at
his time of death. Would this value also be included in Bob’s probate estate and therefore gross estate?
Answer: Yes. Although Bob had not received the check, he was legally entitled to the property at the time of his
death, and therefore it will be included in both his probate estate and gross estate.
Specific InclusionsBesides property in the probate estate, the gross estate also includes property transferred
automatically at the decedent’s death. These automatic transfers can occur without the help of a probate court
because the ownership transfers by law at the time of death.
Certain automatic property transfers are specifically included in the gross estate because, while the decedent
didn’t own the property at death, Congress deemed that the decedent controlled the ultimate disposition of the
property. That is, the decedent effectively determined who would receive the property at the time of death. A
common example is property held in joint tenancy with right of survivorship which legally transfers to the
surviving tenant upon the joint tenant’s death. Joint bank accounts are commonly owned in joint ownership with
right of survivorship. In contrast, tenants in common hold divided rights to property and have the ability to
transfer these rights during their life or upon death. Property held by tenants in common, such as real estate,
does not automatically transfer at death and thus must be transferred via probate. Although the decedent’s
interest in jointly owned property (with the right of survivorship) ceases at death, the value of the interest the
decedent held in this property is still included in the gross estate.14
Example 14-12
Nate and his father jointly own two parcels of real estate not included in the inventory above. One parcel is a
vacation home in Colorado. Nate owns this property jointly with Bob and the title is held in joint ownership with
the right of survivorship. Will this property be included in Bob’s probate estate and/or gross estate?
Answer: The property will not be included in Bob’s probate estate, but it will be included in Bob’s gross estate.
When Bob died, Nate automatically became the sole owner of the property without going through probate.
However, the property will be included in Bob’s gross estate because it is an automatic transfer that is
specifically included in the gross estate by law.
Page 14-19
The second parcel is real estate in west Texas that Nate and Bob hold as equal tenants in common. Will it be
necessary to probate this parcel of real estate to transfer ownership of Bob’s share to the beneficiary named in
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Answer: Yes. The value of Bob’s one-half interest in the west Texas real estate is also included in his gross
estate.
Another example of an automatic transfer is insurance on the life of the decedent. Proceeds of life insurance paid
due to the death of the decedent are specifically included in the gross estate if either of two conditions is met.
The proceeds are included in the gross estate if (1) the decedent owned the policy or had “incidents” of
ownership such as the right to designate the beneficiary or (2) the decedent’s estate or executor is the
beneficiary of the insurance policy (that is, the executor must use the insurance proceeds to discharge the
obligations of the estate).
Example 14-13
Bob owned and paid annual premiums on an insurance policy that, on his death, was to pay the beneficiary of
his choice $500,000. Bob named Nate the beneficiary, and the insurance company paid Nate $500,000 after
receiving notification of Bob’s death. Will Bob’s gross estate include the value of the insurance proceeds paid to
Nate?
Answer: Yes. The $500,000 of insurance proceeds is specifically included in Bob’s estate despite the fact that it
was paid directly to Nate and did not go through probate.
What if: Suppose Bob transferred ownership of the policy to Nate four years prior to his death. Nate had the
power to designate the beneficiary of the policy, and he also paid the annual premiums. Will Bob’s gross estate
include the value of the insurance proceeds paid to Nate?
Answer: No. Bob had no incidents of ownership at his death (Nate controlled who is paid the proceeds upon
Bob’s death), and the proceeds were not paid to his estate.
Jointly owned property.The proportion of the value of jointly owned property included in the gross estate
depends upon the type of ownership. When a decedent’s interest is a tenancy in common (i.e., there is no right
of survivorship), a proportion of the value of the property is included in the gross estate that matches the
decedent’s ownership interest. For example, consider a decedent who owned a one-third interest in property as a
tenant in common. If the entire property is worth $120,000 at the decedent’s death, then $40,000 is included in
his gross estate.
The amount includible for property held as joint tenancy with the right of survivorship depends upon the marital
status of the owners. When property is jointly owned by a husband and wife with the right of survivorship, half
the value of the property is automatically included in the estate of the first spouse to die.15 For unmarried coowners, the value included in the decedent’s gross estate is determined by the decedent’s contribution to the total
cost of the property. For example, consider a decedent who provided two-thirds of the total cost of property held
as joint tenants with the right of survivorship. If the entire property is worth $240,000 at the decedent’s death,
then two-thirds ($160,000) is included in his gross estate.
Page 14-20
Example 14-14
Bob and Nate originally purchased the Colorado vacation home seven years ago for $20,000 and held it as joint
tenants with the right of survivorship. This property is not included in the list of property in Bob’s probate estate
because the title passes automatically to Nate upon Bob’s death. Bob provided $15,000 of the purchase price,
and Nate provided the remaining $5,000. The property was worth $400,000 at Bob’s death. How much is
included in his gross estate?
Answer: Bob’s gross estate includes $300,000. For property held in joint tenancy with the right of survivorship,
the amount included in the gross estate is equal to the proportion of the purchase price provided by the decedent.
Bob provided 75 percent ($15,000 ÷ $20,000 = 75%). Hence, his gross estate will include $300,000 (75% ×
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What if: Suppose Bob was married and owned the home with his wife as joint tenants with the right of
survivorship. What amount would be included in Bob’s gross estate?
Answer: The amount included in the estate is half the value of any property held with the surviving spouse as
joint tenants with the right of survivorship, $200,000 in this case.
The west Texas land Bob and Nate owned is valued at $500,200. They owned it as tenants in common, with Bob
holding a one-quarter interest and Nate holding the rest. What amount is included in Bob’s gross estate?
Answer: The amount included in the estate is $125,050 ($500,200 × 25%), because Bob owned a one-quarter
interest in the property.
Exhibit 14-7 summarizes the rules for determining the value of jointly owned property included in a decedent’s
gross estate.
EXHIBIT 14-7
EXHIBIT 14-7Amount of Jointly Owned Property Included in Gross Estate
Transfers within three years of death.Certain transfers, such as transfers of life insurance policies, made within
three years of the decedent’s death are also included in the decedent’s gross estate, valued as of the time of death.
Without this provision, a simple but effective estate tax planning technique would be to transfer ownership in a
life insurance policy just prior to the decedent’s death. This strategy, called a deathbed gift, would reduce the
decedent’s transfer taxes on the life insurance by the difference between its proceeds from the policy (the value
at death) and its value on the date transferred.
Only certain transfers are specifically included under this provision, and they are often difficult to identify.
Gift taxes paid on transfers within three years of death.Gift taxes paid on any taxable gifts during the three-year
period preceding the donor’s death are also included in the decedent’s gross estate. This inclusion provision
prevents donors from escaping estate tax on the amount of gift taxes paid within three years of death. In other
words, the amount of gift taxes paid are included in the estate because these amounts would have been included
in the estate had the decedent kept the property until death.
Page 14-21
Example 14-15
What if: Suppose Bob owned a life insurance policy, and he transferred all incidents of ownership in the policy
to his son one year before dying from a fatal disease. Suppose that Bob paid $40,000 of gift taxes on the transfer
and the policy paid his son $3 million on Bob’s death. What amount would be included in Bob’s gross estate?
Answer: $3,040,000. Bob’s estate would include proceeds of the policy ($3 million) because Bob transferred the
incidents of ownership within three years of his death. The value of the transfer would also include the gift taxes
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ValuationProperty is included in the gross estate at the fair market value on the date of the decedent’s death.
Virtually all the factors (and controversies) regarding valuation that we’ve already discussed with the gift tax
also apply to the valuation of property for estate tax purposes.
Example 14-16
At his death Bob owned an original landscape painting made in the late 1800s by one of his ancestors, Tully
Smith. Bob purchased the Smith painting for $25,000 in 1980, and last year an expert estimated it was worth
$210,000. Nate now has the painting appraised by another expert, who estimates its value at $250,000 based
upon a painting by the same artist that sold at auction last month. What value should be placed on the painting
for inclusion in the gross estate?
Answer: Nate should value the painting at $250,000 according to its specific characteristics and attributes (such
as age, condition, history, authenticity, and so forth). Of course, the IRS might disagree with this value and seek
to value the painting at a higher value.
THE KEY FACTS
Valuation of Assets
Property is included in the estate at its fair market value at the date of the decedent’s death.
The executor can elect to value the estate on an alternate valuation date, six months after death, if it
reduces the gross estate and estate tax.
The executor of an estate, however, can elect—irrevocably—to have all the property in the gross estate valued
on an alternative valuation date. The alternative date for valuing the estate is six months after the date of death
or on the date of sale or distribution of the property (if this occurs before the end of the six-month period). This
election is available only if it reduces the value of the gross estate and the combined estate and generationskipping taxes.16
Example 14-17
What if: Bob’s shares of FPP are included in his estate at a value of $9.5 million. Suppose the value of the shares
plummeted to $5 million several months after Bob’s death. Suppose that the drop in value caused the value of
Bob’s estate to drop from $18 million to $13.5 million. Could Nate as executor of Bob’s estate opt to value these
shares at the lower cost for estate tax purposes?
Answer: Yes. Nate could elect to value the shares on the alternate valuation date, six months after Bob’s death.
However, to qualify for this election, he must value all property in the estate on the alternate date. Because the
election will reduce the value of the entire gross estate, Nate could make the election to use the alternate
valuation date.
Page 14-22
Example 14-18
At the time of his death Bob owned a reversion in a trust he established for his niece, Dina. Under the terms of
the trust, Dina is entitled to income for her life (a life estate), and Bob (or his heir) is entitled to the reversion. At
the time of Bob’s death, the trust assets were valued at $100,000, Dina was 35, and the §7520 interest rate was 6
percent. Should this reversion be included in Bob’s gross estate and, if so, what value is placed on the future
interest?
Answer: Bob’s reversion interest is included in his estate because this is a property right he owned at his death.
Under Table S in the regulations (Exhibit 14-4), based upon Dina’s age and the current interest rate at the time of
Bob’s death, the percentage of the property that represents the value of Bob’s reversion is 0.11217. Thus, his
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What if: Suppose the trust was established for George, age 6. Would this influence the value of Bob’s reversion
interest?
Answer: Yes. Under Table S in the regulations and based upon George’s age and the current interest rate, the
portion of the property that represents the value of Bob’s reversion is 0.02749. Thus, Bob’s reversion is valued at
$2,749 ($100,000 × 0.02749).
Gross Estate SummarySo far we’ve seen that the decedent’s gross estate consists of the assets subject to probate
as well as certain assets transferred outside probate. These latter assets include property owned by the decedent
in joint tenancy with the right of survivorship as well as life insurance. The gross estate also includes certain
property transferred by the decedent within three years of death and certain future interests owned by the
decedent.
Example 14-19
Given previous examples, what is the value of Bob’s gross estate?
Answer: It is $11,250,717, calculated as follows:
The Taxable Estate
Referring to the estate tax formula in Exhibit 14-6, we calculate the taxable estate in two steps. The first consists
of reducing the gross estate by deductions allowed for administrative expenses, debts of the decedent, and losses
incurred during the administration of the estate. These deductions are allowed because Congress intends to tax
the amount transferred to beneficiaries. This step results in the adjusted gross estate. In the second step, the
adjusted gross estate is reduced for transfers to a decedent’s spouse (the marital deduction) and to charities (the
charitable deduction). These deductions result in the taxable estate. We discuss each type of deduction next.
Page 14-23
Administrative Expenses, Debts, Losses, and State Death TaxesDebts included in or incurred by the estate, such
as mortgages and accrued taxes, are deductible. Expenses incurred in administering the estate are also
deductible, such as executor’s fees, attorneys’ fees, and the like. Funeral expenses are deductible, including any
reasonable expenditure allowed under local law. Casualty and theft losses are deductible without any floor
limitation. These losses must be incurred during the administration of the estate, otherwise the deduction
belongs to the new owner of the property. Finally, death taxes imposed by the state are also deductible.17
Example 14-20
Nate paid $6,685 in funeral expenses for his father’s services, and during the administration of his father’s estate
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totaling $100,500. Since Michigan has no state death or inheritance taxes, no amounts were owed to the state.
What is Bob’s adjusted gross estate (gross estate minus expenses and debts)?
Answer: It is $11,130,000, calculated as follows:
The estate may collect income earned during its administration and, therefore, the estate will need to file an
estate income tax return. The executor has the option of deducting administration expenses (but not funeral
expenses) and casualty and theft losses on the estate tax return or on the estate’s income tax return. While no
double deduction is available, the choice is relatively simple. If the estate owes no estate taxes, then the executor
should claim the deduction on the estate income tax return. If the estate owes estate taxes, the marginal estate tax
rate is likely to be higher than the marginal income tax rate. Hence, it should probably claim the deduction on
the estate tax return.
What if: Suppose that during the administration of Bob’s estate a storm damaged the Colorado vacation home.
Bob’s share of the casualty loss to the home was $25,000. Would this be deductible in calculating Bob’s taxable
estate?
Answer: Yes, although the executor can choose to deduct this loss on either the estate tax return or the estate’s
income tax return for the period that included the casualty. If the deduction is claimed on the estate tax return,
the loss deduction is not subject to any floor limitations (such as the per casualty floor limitation and the 10
percent of AGI limits imposed on casualty losses claimed in individual income tax returns).
Marital and Charitable DeductionsTo avoid taxing a married couple’s estate twice, Congress provides a
deduction for bequests to a surviving spouse. To qualify for the marital deduction, the transferred property must
be included in the estate of the deceased spouse. That is, the surviving spouse must receive the property from the
decedent and control its ultimate disposition. For example, property that passes to the surviving spouse as a
result of joint tenancy with the right of survivorship qualifies for the marital deduction, as would a direct bequest
from the decedent. In contrast, transfers of property rights that are terminable do not generally qualify for the
estate marital deduction (as discussed earlier, terminable interests are treated similarly for gift tax purposes). For
example, suppose the decedent bequeaths the surviving spouse the right to occupy the decedent’s residence until
such time as the spouse remarries. The value of the right to possess the residence is a terminable interest and is
not eligible for the marital deduction.18
THE KEY FACTS
Estate Tax Deductions
Estate tax deductions include the debts of the decedent, funeral expenses, and the costs of administering
the estate, including casualty losses.
The value of property interests bequeathed to a surviving spouse is deductible if the interest is not
terminable.
The value of property bequeathed to a qualified charity is deductible.
In general, the estate tax marital deduction is unlimited in amount. Hence, no tax would be imposed on a
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Charitable contributions of property are also deductible without any limitation. Charities are defined to include
the usual public organizations (corporations organized exclusively for religious, charitable, scientific, literary, or
educational purposes) but exclude certain nonprofit cemetery organizations. Interestingly, foreign charities
qualify for the charitable deduction under the estate and gift tax but not under the income tax. No deduction is
allowed unless the charitable bequest is specified under the last will and testament or is a transfer of property by
the decedent before his death that is subsequently included in the decedent’s estate. The amount of any bequest
must be mandatory, although another person such as the executor can be given discretion to identify the
charitable organization.
Example 14-21
Not long after Bob’s death, Nate gathered the Smith family for a reading of Bob’s will. The will was relatively
simple because Bob was unmarried at the time of his death. Bob had an adjusted gross estate of $11,130,000 and
left all his property to Nate, with two exceptions. Bob bequeathed his remainder interest in the Dina Trust (value
of $11,217) to Dina, and he bequeathed the Smith painting (value of $250,000) to the Midwest Museum in Ann
Arbor (a qualified charity). Is either of these bequests deductible in calculating Bob’s taxable estate? What is
Bob’s taxable estate?
Answer: The bequest to the museum qualifies for the charitable deduction because the museum is a qualified
charity. Since Bob was unmarried at his death, none of the bequests qualify for the marital deduction. Bob’s
taxable estate is $10,880,000 calculated as follows:
What if: Suppose Bob was married at the time of his death and left a portion of his FPP stock, valued at $4.5
million, to his surviving spouse. What amount of this transfer, if any, would qualify for the marital deduction?
Answer: Bob’s estate would be entitled to a marital deduction of $4.5 million, the value of the entire spousal
bequest. In the extreme, if Bob had left all his property to his spouse, then his taxable estate would be reduced to
zero.
Page 14-24
Computation of the Estate Tax
Three additional steps are necessary to calculate the estate tax liability from the taxable estate. First, the taxable
estate is increased by adjusted taxable gifts to compute cumulative lifetime transfers (the estate tax base). Next,
the tax on cumulative lifetime transfers is computed and reduced by the tax payable on adjusted taxable gifts
(computed using the current tax rates). This results in a tentative tax that is reduced by the applicable (unified)
credit.
In contrast to the gift tax formula, the estate tax formula only allows a reduction for taxes payable on adjusted
taxable gifts. Taxes payable are a hypothetical amount computed using the past amount of applicable credit but
the current tax rate schedule. Another difference with the gift tax formula is that the entire applicable credit (not
just the unused portion) reduces the tentative tax (because all prior transfers are included in the tax base). These
differences are illustrated below.
Adjusted Taxable GiftsAdjusted taxable gifts are taxable gifts other than transfers already included in the gross
estate. For example, the value of life insurance transferred within three years of death would not be included in
adjusted taxable gifts but the value of the life insurance proceeds paid at death would be included in the estate.
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Despite increasing cumulative transfers, adjusted taxable gifts are not subject to double tax because the tentative
tax on cumulative transfers is reduced by a credit for the taxes payable on adjusted taxable gifts calculated under
the current tax rate schedule. It is important to note that although adjusted taxable gifts were made in prior years,
all tax calculations are made using the current rate schedule.
Example 14-22
After reviewing all Bob’s records, Nate determined Bob had made only one taxable gift of FPP stock in 2009.
This transfer resulted in a taxable gift of $1 million, the tax on which was offset by the unified credit. What is
the amount of cumulative transfers subject to estate tax, and what is Bob’s tentative estate tax (tax prior to
credits)?
Answer: Bob’s estate includes $11,880,000 of cumulative taxable transfers and Bob’s gross estate tax is
$4,697,800 calculated as follows:
What if: Suppose Bob had not made any taxable gifts prior to his death. Would this fact reduce his tentative tax?
Answer: Without the gift of stock Bob’s tentative tax would be $4,297,800 calculated as follows:
Note that Bob’s tentative tax has decreased by $400,000. This is the amount of tax on the $1 million 2009 gift at
the top marginal rate (40%).
What if: Suppose that Bob’s 2009 taxable gift was $4 million and the gift tax exemption equivalent in 2009 was
$1 million. What is the amount of the reduction of taxes payable on adjusted taxable gifts?
Page 14-25
Answer: $1.2 million. The adjusted taxable gift of $4 million would result in a tax of $1,545,800 under the
current rate schedule. However, because the transfer was made in 2009, the tax would be reduced by $345,800.
This is the amount of the unified credit of $1 million calculated using the current tax rate schedule. The
calculation would be made as follows:
Note that the credit is 40 percent of the gift in excess of the exemption equivalent ($4,000,000 − $1,000,000 =
$3,000,000). The $4 million prior taxable transfer is included in the calculation of Bob’s cumulative taxable
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Hence, the adjusted taxable gift increases the amount of Bob’s estate subject to the top estate tax rate. The
adjusted taxable gift is not subject to an additional transfer tax at the time of Bob’s death for two reasons. First,
the tax payable on the adjusted taxable gift is deducted when computing the tentative tax. Second, the $1 million
of the adjusted taxable gift that is not offset by the taxes payable will be offset by the applicable credit when
computing the gross estate tax.
Applicable (Unified) CreditBesides subtracting the credit for tax on adjusted taxable gifts, we reduce the gross
estate tax by several other credits.20 The most important is the applicable credit, because it eliminates the estate
tax on cumulative transfers up to the exemption equivalent (currently $5.45 million). Hence, estate taxes are
only imposed on relatively large estates. The objective of the applicable credit is to prevent the application of
transfer tax to taxpayers who either would not accumulate a relatively large amount of property transfers during
their lifetime and/or would not have a relatively large value of assets to pass to heirs upon their death.
THE KEY FACTS
Adjusted Taxable Gifts and the Applicable Credit
Adjusted taxable gifts are added to the taxable estate in calculating cumulative taxable transfers.
Lifetime gifts are not subject to double tax because the tax on cumulative transfers is reduced for taxes on
adjusted taxable gifts.
The unified credit eliminates transfer taxes on estates with relatively small cumulative lifetime and
testamentary transfers (total transfers under the exemption equivalent).
Credit is applied after reducing the total tax on cumulative transfers for taxes payable on adjusted taxable
gifts.
The applicable credit for a surviving spouse is increased by the amount of the deceased spousal unused
exclusion (DSUE). For example, in 2016 a spouse whose deceased spouse died without using any unified credit
is entitled to an exemption equivalent of $10.9 million.
Besides eliminating transfer taxes for relatively small cumulative transfers, the exemption equivalent also acts as
the transfer requirement for filing an estate return. That is, an estate tax return (Form 706) must be filed if the
gross estate plus adjusted taxable gifts equals or exceeds the exemption equivalent. Exhibit 14-8 presents the
first page of 2016 Form 706 for Bob Smith. The deadline for the estate tax return is nine months after the
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EXHIBIT 14-8
EXHIBIT 14-8Page 1 of Form 706 Estate Tax Return for Bob Smith
Page 14-27
Example 14-23
Bob died on February 7 of this year. What amount of estate tax must be paid on his estate, given his prior
taxable gift of $1 million? What is the due date for Bob’s estate tax return?
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Bob’s executor must file the estate tax return (Form 706 in Exhibit 14-8) or request an extension of time within
nine months of Bob’s death (by November 7 of this year).
What if: Suppose that Bob did not make any taxable gifts during his life. What amount of estate tax would be
owed upon his death?
Answer: Bob’s estate would only owe $2,172,000, computed as follows:
In this case, the absence of gifts prior to Bob’s death (no adjusted taxable gifts) would result in a $400,000
savings. This is because over his lifetime Bob made fewer taxable transfers ($1 million in fact).
What if: Suppose that Bob’s 2009 taxable gift was $4 million (instead of $1 million) and the gift tax exemption
equivalent in 2009 was $1 million. What amount of estate tax would be owed upon Bob’s death?
Answer: Bob’s estate would owe $2,572,000, computed as follows:
Bob’s estate tax is not increased by the amount of the adjusted taxable gifts in excess of $1 million because these
gifts were taxed in 2009. The taxes payable on adjusted taxable gifts eliminates the potential for double taxation.
The portion of the 2009 gift that was not taxed in 2009 (recall that $1 million was offset by the applicable
credit), however, is now subject to tax.
What if: Suppose that Bob was predeceased by a wife who left all of her possessions to Bob and, consequently,
did not claim an exemption equivalent. What amount of estate tax would be owed upon his death?
Answer: Assuming that the executor of Bob’s wife filed a estate tax return electing the DSUE, Bob’s estate
would be entitled to claim a unified credit based on a deceased spouse’s unused exclusion. Bob’s estate would
not owe any estate tax computed as follows:
The unified credit in this case is $10.9 million ($5.45 million times 2). The unified credit is calculated using the
tax rate schedule resulting in a credit of $4,305,800.
13§2033. The principle of increasing the gross estate for transfers taking effect at death began with gifts in
contemplation of death. So-called deathbed gifts were a device used to avoid the estate tax in the years before
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14§2040. There are a number of other transfers that are specifically included in the gross estate. For example,
§2036 to §2039 and §2041 address transfers with retained life estates, transfers taking place at death, revocable
transfers, annuities, and powers of appointment. A discussion of these provisions is beyond the scope of this
text.
15In some states joint tenancy with a right of survivorship between spouses is referred to as a tenancy by the
entirety.
16§2032A. An executor can also elect to value certain realty used in farming or in connection with a closely held
business at a special use valuation. Special use valuation allows realty to be valued at a current use that does not
result in the best or highest fair market value. This election is available when the business is conducted by the
decedent’s family, constitutes a substantial portion of the gross estate, and the property passes to a qualifying
heir of the decedent.
17§2053, §2054, and §2058 address expenses, losses, and state death taxes, respectively.
18The restriction on the estate tax deduction for terminable interests is drafted consistent with the gift tax
deduction. As noted previously, Qualified terminable interest properties (QTIPs for short) are an exception to
the nondeductibility of terminable interest property. To qualify, the executor must agree to have qualifying
terminable interests included in the estate of the surviving spouse. A detailed discussion of this exception is
beyond the scope of this text.
19There are other credits that could also apply, but these are beyond the scope of this text. The credit for taxes on
prior transfer is designed to adjust the tax for property that was subjected to estate tax within the last 10 years.
There is also a credit for pre-1977 gift taxes paid on certain pre-1977 gifts that must be included in the gross
estate. Both of these credits are equitable adjustments for potential multiple transfer taxes associated with
sequential deaths and multiple inclusions, respectively. Prior to 2005, there was a credit for state death taxes.
20Other transfers that are required to be included in the gross estate are described in Sec. 2035(a). Discussion of
these transfers are beyond the scope of this text.
21There is an automatic six-month extension to file the estate tax return. However, an estimate of the tax due
must be paid on the due date of the return.

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Page 14-29
WEALTH PLANNING CONCEPTS
LO 14-4
Wealth planning coordinates both income and transfer tax strategies with nontax objectives. Before we explore
transfer tax strategies, recall the third transfer tax, the generation-skipping tax, and the potential for income
taxation of fiduciary entities such as estates and trusts. While these topics are certainly not unimportant, we note
them only in passing because their complexity is beyond the scope of this text.
THE KEY FACTS
Basic Wealth Planning Techniques
A serial gift strategy saves gift taxes by converting a potentially large taxable transfer into multiple
smaller transfers that qualify for the annual exclusion.
Bypass provisions in a will or bypass trusts reduce estate taxes by using the unified credit of the deceased
spouse, transferring some property to beneficiaries other than the surviving spouse.
Testamentary transfers allow a step-up in tax basis to fair market value, thereby eliminating income tax on
unrealized appreciation.
Lifetime gifts eliminate transfer taxes on post-gift appreciation.
The Generation-Skipping Tax
The generation-skipping tax (GST) is a supplemental tax designed to prevent the avoidance of transfer taxes
(both estate and gift tax) through transfers that skip a generation of recipients. For example, a grandparent could
give a life estate in property to a child, with the remainder to a grandchild. When the child dies and the
grandchild inherits the property, no transfer tax is imposed because nothing remains in the child’s estate (the life
estate terminates at death). In this way, the grandparent pays one transfer tax (on the initial gift) to transfer the
property down two generations.
The GST is triggered by the transfer of property to someone more than one generation younger than the donor or
decedent—a grandchild rather than a child. A transfer to a grandchild is not subject to GST, however, if the
grandchild’s parents are dead. The GST is very complex and can be triggered directly by transfers or indirectly
by a termination of an interest. Fortunately, the GST is not widely applicable because it does not apply to
transfers that qualify for an annual gift tax exclusion and each donor/decedent is entitled to a relatively generous
aggregate exemption ($5.45 million in 2016).
Income Tax Considerations
A fiduciary entity is a legal entity that takes possession of property for the benefit of a person. An estate is a
fiduciary that comes into existence upon a person’s death to transfer the decedent’s real and personal property.
Likewise, a trust is also a fiduciary whose purpose is to hold and administer the corpus for other persons
(beneficiaries). While an estate exists only temporarily (until the assets of the decedent are distributed), a trust
may have a prolonged or even indefinite existence. Because fiduciaries can exist for many years, special rules
govern the taxation of income realized on property they hold. These rules are complex and relate to how
fiduciaries account for income under state law. A detailed discussion is beyond the scope of this text, but we can
provide a useful general outline.
The trust or testamentary instrument (or, in the absence of an instrument, state law) determines how income and
expenses are allocated between beneficiaries—fiduciary accounting income belongs to income beneficiaries and
corpus (principal) belongs to the remainderman. For example, an instrument may allocate gains on the sale of
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to accounting income whereas repairs may be allocated to corpus. Accounting income is important because it
determines how much income the fiduciary can (or must) distribute. Trusts and estates may have discretion
whether to accumulate income within the fiduciary (for future distribution) or make current distributions.22
Income retained by the fiduciary is taxed as income to the fiduciary, and consequently, the fiduciary must file an
income tax return. In contrast, income distributed currently by the fiduciary is taxed as income to the
beneficiary. To accomplish this flow-through of income, fiduciaries are granted an income tax deduction for
current distributions of income and this deduction depends, in part, on accounting income.
Page 14-30
To better understand how taxable income is divided between a fiduciary and its beneficiaries, it is helpful to first
summarize the formula for determining a fiduciary’s taxable income.23 With few exceptions, the formula for
calculating a fiduciary’s taxable income is analogous to the individual income tax formula. Gross income for a
fiduciary is determined in the same manner as gross income for an individual. For example, trusts are generally
taxed on realized income, but they can exclude certain items from gross income, such as municipal interest, and
make elections to defer certain items, such as installment gains. A fiduciary can also deduct expenses similar to
an individual. For example, a fiduciary can deduct trade or business expenses, interest, taxes, casualty losses,
charitable contributions, and miscellaneous itemized deductions. Although a fiduciary is not entitled to a
standard deduction (i.e., there is no distinction between deductions for AGI and itemized deductions),
miscellaneous itemized deductions for a fiduciary are still subjected to a 2 percent limitation calculated using a
hypothetical AGI. A fiduciary is also allowed a personal exemption, $600 for an estate and $300 for a trust that
distributes all income currently, and $100 for other trusts. Lastly, a fiduciary is allowed a deduction for
distributions of income to beneficiaries. It is this distribution deduction that operates to eliminate the potential
for double taxation of income.
The maximum amount of the distribution deduction (and the maximum aggregate amount of gross income
reportable by beneficiaries) is determined by reference to distributable net income (DNI). DNI is calculated by
adjusting taxable income for the fiduciary, but unfortunately, this calculation is circular. That is, taxable income
for a fiduciary depends upon the distribution deduction, which in turn depends upon DNI, which in turn depends
upon taxable income. Moreover, the calculation of fiduciary taxable income is further complicated by items such
as net operating losses, net capital losses, charitable contributions, multiple beneficiaries, and discretionary
(versus mandatory) distributions. Suffice it to say that the calculation of income tax for a fiduciary can be a very
complicated matter.
While granting a fiduciary discretion over distributions complicates the calculation of taxable income, it might
appear that this discretion also provides an opportunity to split income (by creating yet another taxpayer).
However, the fiduciary income tax rates are generally as high as or higher than the tax rates for individual
beneficiaries. Hence, the potential income tax benefits from splitting income between fiduciaries and
beneficiaries are typically negligible.
Transfer Tax Planning Techniques
Transfer tax planning strategies are the same as those employed for income tax planning: timing, shifting, and
conversion. Like income tax planning, wealth planning is primarily concerned with accomplishing the client’s
goals in the most efficient and effective manner after considering both tax and nontax costs. For the most part,
wealth planning is directed to maximizing after-tax wealth to be transferred from an older generation to a
younger generation. A critical constraint in this process, however, is determining how tax strategies can achieve
the client’s ultimate (nontax) goals. Before attempting to integrate tax and nontax considerations, let’s survey a
few basic techniques for transfer tax planning.
Serial Gifts
A serial gift strategy converts a large taxable transfer into a tax-exempt transfer by dividing the transfer into
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the transfers are exempt from all transfer taxes. Although serial gifts are an easy and low-cost planning strategy,
this technique is limited in scope because only $14,000 ($28,000 if married) can be transferred each year taxfree to any specific donee. Hence, serial gifts can move significant amounts of wealth only if employed by
multiple donors over multiple years and multiple donees.
Page 14-31
Example 14-24
Suppose Harry and Wilma decide to begin transferring wealth to Dina and George. To what extent can serial
gifts accomplish this goal without triggering gift taxes?
Answer: Harry and Wilma could make annual gifts of $14,000 each to Dina and George. These gifts would
remove $56,000 per year from the Smiths’ estate without triggering any transfer taxes (gift tax or generationskipping tax). They could include any type of property as long as Dina and George can presently enjoy the
property or income generated by it.
The Step-Up in Tax BasisTiming is an important component in tax planning. Generally, a good tax strategy
delays payment of tax, thereby reducing the present value of the tax paid. While deferral is important, transfer
tax planning must also consider the potential appreciation of assets transferred, and the effect of the income tax
that could apply if and when the appreciation is realized. Gifted property generally retains the donor’s basis in
the property (the donee takes a carryover basis), whereas inherited property takes a tax basis of fair market
value. The advantage of gifting property is that the donor eliminates the transfer tax on any additional future
appreciation on the gifted property. The disadvantage is that the unrealized appreciation of the gifted property
will eventually be taxed (although at the donee’s income tax rate). Thus, gifting appreciating property reduces
future transfer taxes but at the cost of additional future income taxes imposed on the donee. In contrast, for
inherited property, past appreciation (up to the date of death) will never be subject to income tax but instead is
subject to transfer tax at the time of the transfer.
Example 14-25
What if: Harry currently owns 30 percent of the outstanding shares of FFP. These shares have a basis of
$300,000 but are worth in excess of $2.7 million. Suppose Harry intends to transfer his FPP shares to his
daughter Dina who, in turn, intends to sell them after Harry’s death. To what extent should income tax
considerations influence whether Harry transfers these shares via inter vivos gift or testamentary transfer?
Estimate the total tax savings if Harry delays the transfer of the shares until his death three years hence. Assume
that the transfer (whether by gift or inheritance) will be taxed at the top transfer rate of 40 percent, while when
Dina sells the shares in three years the gain will be taxed at a capital gains tax rate of 20 percent. Let’s also
assume that the FPP shares will not appreciate and the prevailing interest rate is 6 percent.
Answer: The total tax savings is $686,260 if Harry delays the transfer until his death rather than gifting the
shares to Dina immediately. See the following discussion and computations:
If a sale is planned, then the step-up in tax basis becomes critical to avoid being taxed on the accumulated
appreciation. In this scenario, a testamentary transfer provides a step-up in tax basis and delays payment of the
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What if: Suppose Dina has no interest in selling the family business and intends to eventually transfer the shares
to George. Moreover, suppose Harry believes the FFP shares will appreciate to $3.5 million within three years.
To what extent should income tax considerations influence whether Harry transfers these shares immediately via
intervivos gift or in three years via testamentary transfer? Estimate the total tax savings if Harry transfers the
shares immediately rather than delaying the transfer until his death.
Answer: The tax savings is $113,720 if Harry transfers property immediately rather than delaying the transfer
until his death. See the following discussion and computations:
If Dina plans to hold the shares indefinitely and the property is rapidly appreciating, then an inter vivos gift
avoids having future appreciation taxed in Harry’s estate. Although a gift of the shares would accelerate the
imposition of transfer taxes, any unused unified credit could minimize the amount of taxes due on the transfer.
In this scenario, an intervivos transfer reduces total transfer taxes even though the gift tax is paid three years
before an estate tax would be due.
Timing becomes critical in determining how to trade off income tax savings (the step-up in tax basis) against
transfer tax costs (paying gift tax now or paying estate taxes on additional appreciation later). Most tax advisors
will suggest that elderly clients sell business assets or investments with unrealized losses, because upon death
the basis of these assets will be adjusted downward to fair market value. In other words, the adjustment to basis
can be a step-down as well as a step-up, and a sale prevents the elimination of the loss deduction.
Integrated Wealth Plans
A client can have many nontax goals associated with the ultimate disposition of wealth, and some are very
personal. It is often difficult to ascertain and prioritize them for planning purposes. However, an effective wealth
plan must identify and integrate these personal objectives with tax costs. Often, the primary nontax objective of
wealth planning is to preserve value during the transfer of control (management) of business assets. Thus, an
essential nontax element of any effective wealth plan is to identify a safe mechanism to support the older
generation in a specific lifestyle while transferring control to the younger generation.
Trusts are common vehicles for tax planning, in large part because these fiduciaries can be structured to achieve
a great variety of tax and nontax objectives, including the support of specific beneficiaries.24 The trustee is
responsible for managing property in the trust, but the grantor also gives the trustee discretionary powers to
provide flexibility. These powers can include the discretion to distribute income or corpus among beneficiaries.
In addition grantors can retain powers, including the ability to revoke the trust, select the trustee (original or
successor), terminate beneficial interests, and add to the corpus. The most important aspect of an irrevocable
trust is that the provisions (including powers and guidelines for the exercise of discretionary powers) cannot be
changed once the trust instrument has been executed.
Page 14-33
Specific types of trusts are common to many wealth transfer plans. For example, a life insurance trust is funded
with an irrevocable transfer of a life insurance policy, and the trustee is given the power to name beneficiaries
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into the trust but not included in the grantor’s estate. Moreover, an immediate cash distribution from the trust is
not taxable income to the beneficiaries.
Example 14-26
Harry is planning to purchase a $2 million life insurance policy. He wants to use the proceeds to support Wilma
after his death and have any remaining funds paid to his surviving children. How would Harry structure a trust
to accomplish these goals?
Answer: Harry should transfer the policy to an irrevocable trust that directs the trustee to hold the policy and pay
the premiums until Harry’s death. At that time, the trustee should be directed to invest the $2 million proceeds
and pay income to Wilma for the remainder of her life or until she remarries. At Wilma’s death or remarriage,
the trust terminates and pays the remaining funds to Harry’s surviving children or their estates.
What if: Suppose Harry transfers the policy to an irrevocable trust and dies four years later. Will the use of this
trust trigger any estate taxes at that time?
Answer: Harry’s transfer of the policy to the trust will be a taxable gift at the time of the transfer to the extent of
the value of the transfer. However, the $2 million proceeds from the policy will not be included in Harry’s estate
upon his death.
Donors often use partnerships to transfer assets and for the control of a business in a systematic manner that also
provides them with income and security. One specific form of partnership, the family limited partnership,
divides a family business into various ownership interests, representing control of operations and future income
and appreciation of the assets. These limited partnerships were sometimes used to transfer appreciation to
members of a younger generation while allowing the older generation to effectively retain control of the
business. Obviously, the intent of the estate and gift taxes is to recognize transfers of assets that also represent
control of the assets. Hence, it was not surprising that Congress revised the law to restrict the ability of family
limited partnerships to effectively transfer appreciation in business assets and operations to younger generations
without also transferring control.
22Regulations under §§ 651–652 make a distinction between simple trusts and complex trusts. Simple trusts
must distribute all trust accounting income currently (and cannot make charitable contributions) whereas
complex trusts are not required by the trust instrument to distribute income currently.
23Subchapter J (§§ 641–692) contains the provisions governing income taxation of fiduciaries.
24Trusts are also popular because the trust property transfers outside probate, thereby avoiding both the costs
and the publicity associated with probate.

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CONCLUSION
In this chapter we learned to identify taxable transfers whether made at death (testamentary transfers) or during
life (inter vivos transfers). We also learned how to calculate estate and gift taxes, and we introduced some
fundamental transfer tax planning techniques. The simplest and most effective wealth planning technique is
serial giving. As long as the gifts are restricted to present interests under the annual exclusion, serial giving
avoids all transfer taxes. Other methods, such as family limited partnerships, can also be effective under the
proper circumstances. In all cases, however, wealth planning should be carefully coordinated with other needs
and objectives.