Wealth Transfer Taxes
A review of the various wealth transfer taxes and how they work.
Federal and state estate, gift, and GST taxes, collectively known as wealth transfer taxes, and the interplay between and among them, are quite complex. Nevertheless, the following is a brief review of what these taxes are and how they work.
The federal estate tax is the oldest of the wealth transfer taxes, and is imposed upon the transfer of wealth at death, whether by will, rules of intestacy, beneficiary designation, etc. The decedent’s gross estate includes essentially all assets owned by the decedent at death, as well as certain assets over which the decedent has a degree of benefit or control that is considered equivalent to ownership. The value of the gross estate is then reduced by certain deductions, including the following, to determine the taxable estate:
- Debts, Taxes, and Administration Expenses. Generally, the estate is entitled to a deduction for any debts that must be paid, any taxes owed at death, including income taxes or estate taxes imposed by a state, and the expenses of administering the estate, including things such as funeral expenses, executor fees, and the cost of preparing an estate tax return.
- Charitable Deduction. Bequests to qualified charities are deducted from the gross estate. Unlike the income tax charitable deduction, which limits the deduction to a percentage (no more than 50%, and often much less) of “adjusted gross income,” there is no limit on the degree to which the charitable deduction may reduce a taxable estate, so a decedent can avoid estate tax entirely by leaving the entire estate to charity.
- Marital Deduction. A bequest to a U.S. citizen spouse is deducted from the gross estate if the bequest is either outright or to a trust that meets certain qualifications, such as that all income must be distributed to the spouse, no distributions may be made to anyone other than the spouse, and the trust must be included in the spouse’s gross estate at death.
- Estate Tax “Exemption.” After all deductions are taken, the estate tax is imposed on the remaining “taxable estate” to the extent that it exceeds the amount that is effectively exempt from estate tax, technically known as the applicable exclusion amount.1 The amount of the estate tax exemption is indexed annually for the cost of living. For decedents dying in 2022, the applicable exclusion amount is $12,060,000, subject to two key adjustments:
- Reduction for Lifetime Taxable Gifts: The applicable exclusion amount is reduced by the amount of the decedent’s cumulative lifetime taxable gifts that used any portion of the applicable exclusion amount prior to death;
- Increase for DSUE: The applicable exclusion amount is increased by the amount of any deceased spouse unused exclusion, or “DSUE”, that was not used by the decedent’s predeceased spouse, but only if the proper procedures to elect “portability” of the exclusion are followed at the first death. Note that while a surviving spouse’s applicable exclusion amount continues to be indexed for inflation following the first death, the predeceased spouse’s DSUE does not increase; and
- “Anti-Clawback” Provision: If the basic exclusion amount is reduced2 below an amount that has been applied against lifetime gifts, the difference is added to the exclusion amount for estate tax purposes.
- Rate and Payment of Tax. The federal estate tax is imposed on the estate at a flat rate of 40% of the taxable estate, to the extent that it exceeds the applicable exclusion amount, including the portion of the estate used to pay the estate tax.
- Please see the discussion below regarding the calculation of the gift tax, which results in a lower tax and a larger transfer, since the gift tax is not calculated on the funds used to pay the tax.
- State Estate Tax. Only about one-third of the states impose a state estate tax on decedents’ estates, generally at rates of up to 19%. All such states provide that a portion of the estate is exempt from estate tax, but most state exemptions are lower than the federal applicable exclusion amount. Lifetime taxable gifts can affect state estate tax liabilities in a few states, but are ignored in all other states, so in those other states, lifetime taxable gifts essentially avoid any state transfer tax. Only two states, Hawaii and Maryland, allow a surviving spouse to use any exemption not used by a predeceased spouse.
- State Inheritance Tax. A handful of states impose an inheritance tax on the persons receiving property from an estate. Some states provide exemptions or lower rates for amounts inherited by immediate family members. A few states impose both estate and inheritance tax.
- Federal Deduction for State Death Tax Paid. For federal estate tax purposes, estates are entitled to a deduction for any state death tax paid, but the deduction does not result in a complete offset of the state tax liability. Therefore, the estates of decedents in states imposing a state death tax generally have a higher aggregate death tax burden than those in states that do not impose any such taxes.
The federal gift tax is generally imposed on all lifetime transfers of property for “less than an adequate and full consideration,” other than transfers in the ordinary course of business. The gift tax was enacted after the estate tax as a “backstop” to the estate tax, because prior to that time, substantial gifts during lifetime would avoid transfer tax entirely — the gifts were out of the taxable estate, and there was no tax on gifts. Several significant exceptions, exclusions, and deductions apply with respect to gift tax.
- Charitable Deduction. Just as transfers to charity at death avoid estate tax, gifts to qualified charities during lifetime are not subject to gift tax, and no limitation exists as to the amount of gifts that qualify for the charitable deduction. Whether such gifts must be reported on a federal gift tax return depends upon a number of circumstances.
- Marital Deduction. Gifts to a U.S. citizen spouse are not subject to gift tax if the gift is either made outright or to a trust that meets certain qualifications.3 Again, no limit applies on this deduction, and the same requirements for the estate tax marital deduction apply with respect to the gift tax marital deduction.
- Educational Tuition Exclusion. Direct payments of tuition to an educational institution, including private elementary or high school, trade school, college, postgraduate, etc., are excluded from gift tax. No limits exist on the amount of such payments that may be excluded or the number of students for whom such payments may be made, nor are there any requirements that the student be related to you. However, great care must be taken to make sure that the payment meets the requirements of the exclusion, and the assistance of counsel is strongly recommended. This exclusion is unique to the gift tax, and no similar exclusion exists for the estate tax.
- Medical Expense Exclusion. Direct payments of certain medical expenses, such as doctor bills, prescription drugs, and medical insurance premiums, are excluded. As with the tuition exclusion, no limits are applicable on amounts of payments or the number of patients for whom payments are made, nor is there any need for a family relationship. Again, however, advice of counsel is strongly recommended to ensure compliance with the rules. This exclusion is unique to the gift tax, and no similar exclusion applies for the estate tax.
- Annual Exclusion. Gifts that do not qualify for any of the foregoing exclusions may qualify for the gift tax annual exclusion, which excludes gifts during the year to any, and every, individual up to the amount of the exclusion, which is $10,000, indexed for the cost of living in $1,000 increments from 1997. For gifts in 2022, the exclusion amount is $16,000 per donee. The annual exclusion applies not only to outright gifts, but to certain gifts in trust. The number of persons to whom you can make annual exclusion gifts is unlimited, and the donees need not be related to you.4 Any unused annual exclusion may not be carried over to a later year, so “use it or lose it.”
- Lifetime Gift Exclusion. Finally, any gifts that do not qualify for any of the foregoing exclusions, and that exceed (or do not qualify for) the annual exclusion, are subject to gift tax only to the extent that your cumulative lifetime taxable gifts exceed the amount of your lifetime gift exclusion, which is actually the same applicable exclusion amount that applies for estate tax purposes, because the exclusion may be used either during lifetime or at death. The applicable exclusion amount includes any DSUE “inherited” from a predeceased spouse if “portability” of exemptions was properly elected. Taxable gifts5 must be reported on a gift tax return, but no tax liability is actually incurred until your cumulative lifetime taxable gifts exceed your applicable exclusion amount. For 2022, the applicable exclusion amount is $12,060,000 (plus DSUE, less prior taxable gifts), just as it is for estate tax purposes.6
- Rate and Payment of Tax. Gift tax is imposed on the donor at the same 40% rate as the estate tax. However, unlike the estate tax, the gift tax is only paid on the amount actually transferred to the donee, and not on the funds used to pay the gift tax. As a result, once a donor’s applicable exclusion amount has been exhausted, taxable gifts during lifetime can result in a larger transfer and a lower tax than holding the property until death. This important result is illustrated by the following examples.
- If a donor with no remaining exclusion makes a taxable gift of $100,000, she pays federal gift tax of $40,000, being 40% of the amount of the gift, for a total “out of pocket” amount of $140,000.
- If the same donor dies with the $140,000 included in the estate, the estate tax burden is $16,000 higher, because the 40% estate tax is imposed on the entire $140,000, so the IRS receives $56,000, and the beneficiary receives only $84,000.
- If the donor dies within three years of the date of the gift, any gift tax paid will be added back to the estate, and the exemption used will be restored, effectively eliminating this calculation benefit of the lifetime gift.
- Gift Splitting. Unlike income tax returns, which can be filed jointly by spouses on an aggregate basis, gift taxes are imposed on each individual spouse separately, each has a separate lifetime gift exemption, and each has separate annual exclusions to be used each year for gifts. However, a married couple may elect to “split” gifts during any year, meaning that all gifts by either spouse during the year are treated as made one-half by each spouse. Thus, for example, one spouse can make a gift of $32,000 under the annual exclusion, if the other spouse consents to split gifts, because the gift is treated as two gifts of $16,000 each. Likewise, gifts that use any portion of the applicable exclusion amount will use equal amounts of each spouse’s exclusion. Note that gift splitting requires the filing of a gift tax return by one or both spouses, and may not be available if one of the spouses is not a U.S. citizen. Moreover, gift splitting is not recommended in some circumstances, so before one spouse makes any gifts intending to rely on gift splitting, counsel should be consulted.
- State Gift Tax. One state (Connecticut) imposes a separate gift tax on lifetime gifts, and one additional state (New York) includes gifts within three years of death in a decedent’s taxable estate.7 With those exceptions, states generally impose no gift taxes. However, that is subject to change at any time, as states seek new sources of revenue.
Federal GST (Generation-Skipping Transfer) Tax
The federal generation-skipping transfer, or GST, tax applies to gifts or bequests, outright or in trust, to a "skip person", meaning someone two or more generations younger than the transferor, typically meaning transfers to grandchildren or younger generations.8
- Purpose of GST Tax. Just as the gift tax was enacted to tax lifetime transfers of property that were beyond the reach of the estate tax, the GST tax was enacted to tax transfers that would otherwise avoid gift or estate tax in one or more generations by either bypassing a generation entirely or by placing property into trusts that benefit succeeding generations of beneficiaries without the property being subject to estate tax in each generation. The GST tax is imposed at the same rate as the estate tax, which is currently 40%, but can be imposed in addition to gift or estate tax.
- Taxable GSTs. A GST may occur upon a direct transfer by gift or bequest to a skip person or to a trust that has only skip persons as beneficiaries. (This is referred to as a "direct skip.") A gift or bequest in trust does not result in an immediate GST if there are any beneficiaries who are not skip persons (i.e., any children-beneficiaries), but a later taxable distribution out of the trust to a skip person (grandchild) will be a taxable GST. Additionally, when the last surviving non-skip person beneficiary dies, and all remaining beneficiaries are skip persons, a taxable termination will occur with respect to the entire trust, but only if the trust property is not included in the estate of the deceased child beneficiary.
- GST Exemption. As is the case with gift and estate tax, each individual has a certain amount of GST exemption that may be allocated to property transfers, thus rendering the property effectively exempt from the GST tax when a GST occurs. If GST exemption is allocated to all gifts to a trust,9 the property of the trust, including accumulated income and capital appreciation on the property, will be exempt from GST tax and will remain exempt from GST tax (and estate tax) for so long as the trust endures, which could be for many generations. Therefore, the GST exemption represents the maximum amount of wealth that a taxpayer can give10 in trust for future generations without the property being subject to any further estate or GST tax in each generation, but the trust assets that can pass free of any GST tax can grow far beyond the amount of the GST exemption. The amount of the exemption is the same as the lifetime exclusion for gift and estate tax, but GST exemption is not always used for the same transfers that use the gift/estate exemption, and vice versa. Therefore, some gifts that are excluded from gift tax are not excluded from GST tax and require the use of GST exemption, and some gifts that require the use of lifetime gift tax exclusion do not require the use of GST exemption, because there is no GST involved. (If all of this sounds rather complex, it is; counsel should assist with GST planning.)
- Medical and Tuition Exclusions. As with gift tax, the GST tax does not apply to any direct payments of tuition or medical expenses on behalf of grandchildren, assuming the rules are followed.
- Annual Exclusion. Outright gifts to grandchildren that qualify for the gift tax annual exclusion will also qualify for an equal exclusion from GST tax. However, many gifts in trust that qualify for the gift tax annual exclusion do not qualify for the GST tax annual exclusion, and require the allocation of GST exemption to avoid the imposition of the tax.
- The “basic applicable exclusion amount” is $5,000,000, indexed for inflation in $10,000 increments for years following 2011. In addition to this amount, the “applicable exclusion amount” also includes some or all of a prior deceased spouse’s applicable exclusion amount that was not used during the spouse’s lifetime or at death if an appropriate “portability” election was made following the prior spouse’s death.
- The basic exclusion amount is scheduled to decline to $5,000,000, indexed for inflation for 2010, in 2026.
- The qualifications for a marital deduction trust are that all income must be paid out to the spouse every year, no principal can be distributed to anyone other than the spouse during the spouse’s lifetime, and any property remaining in the trust at the spouse’s death must be subject to estate tax in the spouse’s estate. If the donee spouse is not a U.S. citizen, tax-free gifts to the spouse are limited to a special annual exclusion.
- There is a special higher annual exclusion applicable to gifts each year to a non-citizen spouse. For 2022, the amount of this exclusion is $164,000, and it is indexed for inflation.
- Gifts during a year, reduced by any of the applicable deductions and exclusions described above, constitute the “taxable gifts” for that year.
- See footnote 1 for an explanation of the applicable exclusion amount.
- The addback in New York applies to certain gifts within three years of death for decedents dying before 2026.
- It can also apply to collateral relations, such as grandnieces and grandnephews, or to unrelated persons who are 37½ years or more younger than the transferor. The tax does not apply to transfers to persons only one generation younger (children, children of siblings, persons less than 37½ years younger), or to persons in the same generation (siblings and first cousins) or in a higher generation (parents, grandparents, aunts, and uncles).
- The GST exemption is typically allocated on a gift or estate tax return. In some circumstances (under some complex rules), the GST exemption is allocated automatically, but a gift or estate tax return can override that automatic allocation.
- GST exemption need be allocated only to gifts. Sales of assets to an exempt trust for full consideration do not require any further GST exemption allocation to maintain the full GST exempt status of the trust.
This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation, or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.