This is one in a series of occasional Under the Hood articles that takes a closer look at issues of concern to advisors and their clients.

Two of the most important issues facing the wealthy are taxes and estate planning.

If you are knowledgeable about these topics you will be in a unique position to advise high-net-worth clients. In this article, we’ll discuss what is included in the gross estate, how assets pass to heirs at death and the steps involved in the federal estate tax calculation. In addition, you’ll find several hyperlinks to the relevant portions of the Internal Revenue Code plus a list of the major estate planning designations and links to learn more. 

Determining the Gross Estate

The Federal Estate Tax was enacted nearly 100 years ago, in 1916, only three short years after the passage of the modern day federal income tax. Since inception, the Federal Estate Tax has been modified multiple times. Perhaps the most significant change was the unification of the Federal Estate and Gift Tax systems in 1976. Today, the maximum Federal Estate Tax rate is 35% on taxable estates of $5.34 million or more. 

The gross estate of a deceased person consists of everything a person owns at death. Internal Revenue Code, Section 2031 defined this as: 

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.

The gross estate encompasses Sections 2032-2046 of the IRC, which includes proceeds of life insurance, powers of appointment and other items. The gross estate also includes the present value of a pension benefit paid to a surviving spouse.

How Assets Pass to Heirs

In general, there are three primary methods for transferring assets at death. They are: 

1) Operation of Law

2) Contract

3) Probate 

Operation of law includes items such as a joint account with rights of survivorship (JTWROS) and other legal titles with survivorship provisions. The contract method pertains to assets with a beneficiary designation such as retirement accounts, annuities, life insurance and T.O.D. accounts. The final method includes all items which do not pass via the first two methods. These are the items transferred through the will.

It should be noted that the first two methods take precedence over the third. For example, if you list a brother as the beneficiary of your life policy, but your cousin is listed as the beneficiary of the policy in your will, the beneficiary designation will prevail and the brother will receive the proceeds. This is an important distinction to understand.

Calculating the Federal Estate Tax

The Federal Estate Tax is calculated on IRS Form 706. The calculation involves a series of steps but follows a process similar to the Federal Income Tax calculation. Here are the steps involved, including all deductions and additions.

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You can follow the steps in the table above for a complete understanding of the estate tax calculation. In addition, there are links to the relevant tax code for several of the items listed.

DEFINITIONS

To assure clarity, I have included the definition of two important terms. They are:

Applicable Exclusion – The value of a taxable estate which is excluded from the Federal Estate Tax. Under current law, the value in 2014 is $5.34 million and is indexed to inflation annually.

Unified Credit – A credit equal to the Federal Estate Tax due on the applicable exclusion. 

Example: In 2014, a person with a taxable estate of $5.34 million (i.e. the applicable exclusion) would owe a Federal Estate Tax of $2,081,800 (i.e., the unified credit). Therefore, a Federal Estate Tax would only be due on taxable estates which exceed $5.34 million.

Paying the Estate Tax

The Federal Estate Tax return must be filed and the tax must be paid within nine months of the date of death. Normally all property is valued as of the date of death. However, an alternate valuation date may be available if the value of the gross estate is lower six months after death.

There is also an installment payment option for qualified estates under IRC Section 6166. To learn more about the entire process, follow this link to the relevant portion of the IRS website

Estate planning is a very deep well and learning it will take time. Perhaps the best way to proceed is to study and acquire an estate planning designation. This will increase your knowledge and help you to communicate with estate planning attorneys. Attorneys can be a good source of referrals if they trust you and if they feel you are reasonably proficient.

Appendix

These are some designations to consider if you’d like to expand your knowledge of estate planning. 

Accredited Estate Planner (AEP)  This is awarded by the National Association of Estate Planners & Councils

Chartered Trust and Estate Planner (CTEP) This is awa rded by the American Academy of Financial Management.

Certified Trust and Financial Advisor (CTFA)This is awarded by the American Bankers Association.

 

See the entire Under the Hood series.