When the wealthy make plans to transition assets to their heirs, they must consider whether it is better to gift during their lifetime or transfer the assets at death. The estate and gift tax schedules were merged in 1976 and the estate tax calculation requires that all post 1976 gifts in excess of the annual exclusion (adjusted taxable gifts) be added back into the estate tax calculation. Then a credit is allowed for gift taxes paid on these gifts. While we won’t address this specific issue we will cover some important information concerning the gross estate, the probate estate, the role of the executor, and how assets pass to heirs at death. Then we’ll conclude with a discussion on lifetime gifting, specifically, the Grantor Retained Annuity Trust (GRAT).
An individual’s gross estate consists of everything they own and is defined in IRS Code Sec 2031(a) as follows:
The value of the gross estate of the decedent shall be determined by including to the extent provided for in this part, the value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.
For determining the value of the gross estate, all assets are valued as of the date of death or the alternate valuation date (six months later). The alternate valuation date option is only available if using it will reduce the value of the gross estate and the net estate tax and generation skipping transfer (GST) taxes due. For instance, let’s assume John dies on January 1 with a gross estate of $3 million, which includes his business valued at $1 million. Six months later his estate is worth $2.3 million due to a decline in the value of the business. Since this would also cause the net federal estate tax to decline, the alternate valuation date may be used instead of the value on the date of his death.
Probate and the Executor
The probate estate is the portion of the gross estate subject to the probate process. Probate is a public process, and in some states is very costly.
When an individual dies, their executor has a fiduciary responsibility to inventory and value all assets, pay all taxes and expenses, and distribute the remaining assets of the estate. As a fiduciary they can be held personally responsible if something goes awry. An executor’s fees will vary but if they are also a beneficiary of the estate, such as a family member, they will often serve without a fee. If an estate tax is due, even if the executor is a family member, it may be advantageous to charge a fee since it is a deduction on the decedent’s federal estate tax return. Fees received by an executor are also subject to income tax but, according to IRS Publication 559, the fee may not be subject to self-employment tax. Here’s what it says:
All personal representatives must include in their gross income fees paid to them from an estate. If paid to a professional executor or administrator, self-employment tax also applies to such fees. For a nonprofessional executor or administrator (a person serving in such capacity in an isolated instance, such as a friend or relative of the decedent), self-employment tax only applies if a trade or business is included in the estate’s assets, the executor actively participates in the business, and the fees are related to operation of the business.
So even though an executor must pay personal income tax on his fee, if he does not meet the “professional” test, there would be no self-employment tax due, resulting in a savings of 15.3%.
How Assets Pass to the Heirs of an Estate
Generally, assets will pass to a decedent’s heirs by one of three methods. The first is by operation of law; next, is by contract; and the last is through the will. It’s important to note that the first two methods take precedence over the will. For instance, if the IRA document listed the decedent’s brother as beneficiary and the will listed the wife, the brother will get the asset. However, if this were a qualified retirement plan instead of an IRA, then the spouse would inherit unless she waived her right. If the IRA had no valid beneficiary listed then it would pass according to the provisions in the decedents will and would be subject to probate. Let’s take a closer look at the three primary methods.
The operation of law method includes such things as titling of assets and is typically found in common law states. For instance, the house may be titled in both spouses names as Joint Tenants with Rights of Survivorship (JTWROS) or Tenants by the Entirety. An investment account may also be titled in the same manner. One spouse may decide to go out and purchase a summer home and title it in their name alone, in which case, 100% of it would be included in their estate. In the case of joint ownership the decedent’s half will automatically pass to the survivor outside of probate.
Operation of law is not very common in community property states plus, if the asset is indeed community property, titling is irrelevant. So if a husband and wife live in a community property state and have a joint investment account which is titled as JTWROS it be will treated as community property even though it is titled otherwise. Currently, community property states include Arizona, California, Idaho, Louisiana, Nevada, Texas, Washington, and Wisconsin. Puerto Rico is also a community property regime and Alaska has an optional system.