The federal government taxes large gratuitous transfers, which are transfers to recipients, usually referred to as beneficiaries, who provided inadequate consideration for the transferred property. Gratuitous transfers can either be gifts given while the donor was still alive or transferred from his estate after his death. Inter vivos gifts may be subject to gift tax and the donor's estate property may be subject to estate tax and both transfers can be subject to a generation-skipping transfer tax. An estate tax is an excise tax on the right to transfer property or interest in the property; by contrast, an inheritance tax is an excise tax on the right to receive the property. The federal government does not assess an inheritance tax, only an estate tax, which is why the estate pays the tax, and not the beneficiaries.
The estate tax was 1st enacted in 1916, not as a revenue generator, but as a tax to prevent the accumulation of wealth in the upper echelons of society, when the richest 1% owned 50% of America's wealth, which many people have argued is a threat to democracy. By 1976, high estate and gift taxes have reduced their proportion of wealth to 20%. However, generous exemptions on the estate tax plus other tax loopholes allowed the wealthy to accumulate more and more wealth so that in 2010, the wealthiest 1% segment owned 1/3 of America's wealth, while 80% of the poorest Americans, those in the lowest 4 quintiles, owned just 16% — in other words, the wealthiest 1% owned twice as much as 80% of Americans. Furthermore, income from gifts, inheritance, or life insurance is not subject to income taxes; hence, it is the least taxed form of income, even though the recipients do nothing for the income.
According to 2016 IRS statistics, only 12,411 estates had to file Form 706, and fewer than half of those owed any taxes: the estimated value of 133 of these estates each exceeded $50 million, so obviously taking advantage of tax loopholes yields even bigger dividends than simply claiming the unified tax credit. The total estate tax collected in 2016 was $18.3 billion on assets estimated to be worth $108 billion, yielding an effective tax rate of 17%. So even the richest estates pay a lower effective tax rate than someone who earns $20,000 by working for it!
The general term death taxes usually refers to both estate and inheritance taxes. An inheritance tax is distinguished from an estate tax in that it is assessed on the donees receiving the gifts rather than the estate. Although the federal government does not impose an inheritance tax, many states do. Another distinguishing feature of the inheritance tax is that the rate often depends on the relationship between the decedent and the beneficiary – the closer the relationship, the lower the tax.
Under the Tax Reform Act of 1976, the gift and estate taxes were considered as a whole, with the same rates and exemption or credit amounts applying to both. When an inter vivos gift was made, the donor did not have to pay for the tax in that year, but the amount was charged against his estate. The 2001 Economic Growth and Tax Relief Reconciliation Act (2001 Tax Act) created different exemption amounts for the gift and estate taxes, starting in 2004, and, in 2010, the gift tax will be 35% while there will be no estate tax. After 2012, both taxes will be subject to a 40% tax rate.
The Tax Reform Act of 1986 created a generation-skipping transfer tax that imposed additional tax on any transfers to beneficiaries more than one generation removed from the decedent—grandchildren and their descendants. So, for example, if the decedent gives his child a life estate in his property with the property going to his grandchild when his child dies, then a generation-skipping transfer tax is imposed upon the property when the child dies. The generation-skipping transfer tax is equal to the highest estate tax rate for the estate after exemptions and exclusions are deducted. Although the 2001 Tax Act repealed the generation-skipping transfer tax and estate tax for 2010, both have returned.
2018 Estate Tax Update
In December 2017, the Republicans have passed their major tax plan, known as the Tax Cuts and Jobs Act, with most of the benefits going to the wealthy. Part of that plan includes decreasing the top estate tax rate from 40% to 35% and doubles the exemption to $11 million for each individual, which will allow a couple to leave $22 million to their heirs tax-free. This exemption is also adjusted for inflation. The Republicans argue that this is to protect small farms and businesses. However, according to Who pays the estate tax? | Tax Policy Center, in 2017, only 690 businesses and farms were large enough to owe an estate tax, and just 80 of them were small farms or businesses. And according to estimates by the United States Department of Agriculture, only 1.7% of farm estates would be required to file an estate tax return for 2016, but only 0.42% would be required to pay any estate tax. Moreover, the tax code already allows taxpayers to pay the estate tax over 14-year period, if at least 35% of the value of the estate is a farm or business. Then there is life insurance, another solution. Nonetheless, the Republicans will advance any argument to rationalize giving most of the tax breaks to the wealthy, even though it is estimated that the US deficit, now more than $20 trillion, will increase by another $1.5 trillion over a 10-year period. Republicans argue that the deficit will not be greater than that since economic growth will help pay for the tax cuts. My bet is that the total debt will increase much faster than that, since the economy is not likely to continue growing at 3 or 4% for the next 10 years, especially since it is already reaching its potential output.
Final Tax Return and Income in Respect of the Decedent
Besides filing a tax return for the estate, the executor must also file a tax return for the decedent. Only income actually or constructively received before death is reported on the decedent's final tax return. This includes business income, if the business used cash-basis accounting. If accrual accounting was used by the decedent's business, then all the income accrued up to the date of death is reported on the final tax return.
Income in respect of a decedent (IRD) is income actually or constructively received after death. IRD income is reported by the estate on the estate tax return and is subject to both income tax to the recipient and estate tax to the estate. IRD income is reported by the recipient of the income and maintains its character, such as ordinary income or capital gains. There is no step up in basis for any IRD property. The estate tax on the IRD is deductible by the recipient. IRC §691
If the decedent had income from installment sales, then the profit portion of each unpaid installment would be considered IRD, which is reported in the gross income of the recipient. However, the executor can elect out of the installment reporting by including the income on the final income tax return.
If the decedent had United States savings bonds, and did not elect to report the accrued interest income on series EE and E bonds, then the executor may do so on the final return. If the election is not made, then the accrued interest is IRD, which is reported on the estate's income tax return. If treated as IRD, then the income is included in the gross income of the recipient, which may be the estate or beneficiary, when the bond is redeemed. Any estate tax attributable to the IRD in the gross estate would be deductible, but only as a miscellaneous itemized deduction subject to the 2% of AGI floor. The estate could elect to report the accrued interest on its income tax return, but because of the compressed tax brackets for estates, it may trigger a large tax, since the highest tax bracket of 39.6% applies any income exceeding $12,300 in 2015. Additionally, the 3.8% medical surcharge tax will also apply for any income exceeding the start of the highest tax bracket.
Estate Income and Deductions
Unlike for individuals and even businesses, an estate can select any fiscal year or the calendar year as its tax year without the consent of the IRS. Thus, the executor is free to choose a fiscal year that will reduce some taxes, by distributing the tax liability over 2 years instead of 1 year, especially IRD taxes. Trusts, which ordinarily must use a calendar year, can also use the fiscal year if included in the estate.
If an estate has investment property, then the estate will earn some income while it exists. Income earned by an estate is subject to the same tax brackets as for a trust:
|Taxable Income (TI)||Tax Liability|
|Base Tax||Additional Tax|
2018:New Republican Tax Plan Brackets (Tax Cuts and Jobs Act)
This new bracket also applies to unearned income subject to the kiddie tax.
|$0||< TI ≤||$2,550||$0||+||10%||×||TI|
|$2,550||< TI ≤||$9,150||$255||+||24%||×||(TI – $2,550)|
|$9,150||< TI ≤||$12,500||$1,839||+||35%||×||(TI – $5,950)|
|$12,500||<||TI||$3,011.50||+||37%||×||(TI – $12,500)|
|$0||< TI ≤||$2,550||$0||+||15%||×||TI|
|$2,550||< TI ≤||$6,000||$382.50||+||25%||×||(TI – $2,550)|
|$6,000||< TI ≤||$9,150||$1,245||+||28%||×||(TI – $5,950)|
|$9,150||< TI ≤||$12,500||$2,127||+||33%||×||(TI – $9,050)|
|$12,500||<||TI||$3,232.50||+||39.6%||×||(TI – $12,400)|
|$0||< TI ≤||$2,550||$0||+||15%||×||TI|
|$2,550||< TI ≤||$5,950||$382.50||+||25%||×||(TI – $2,550)|
|$5,950||< TI ≤||$9,050||$1,232.50||+||28%||×||(TI – $5,950)|
|$9,050||< TI ≤||$12,400||$2,100.50||+||33%||×||(TI – $9,050)|
|$12,400||<||TI||$3,206||+||39.6%||×||(TI – $12,400)|
|$0||< TI ≤||$2,500||$0||+||15%||×||TI|
|$2,500||< TI ≤||$5,900||$375||+||25%||×||(TI – $2,500)|
|$5,900||< TI ≤||$9,050||$1,225||+||28%||×||(TI – $5,900)|
|$9,050||< TI ≤||$12,300||$2,107||+||33%||×||(TI – $9,050)|
|$12,300||<||TI||$3,179.50||+||39.6%||×||(TI – $12,300)|
The estate can claim an exemption of only $600, which is much smaller than the exemption that can be claimed for individuals. Some expenses, such as administration expenses, may be deducted from the income tax return of the estate or from the gross estate for estate tax purposes, but not both. Administrative expenses, under IRC §2053, and casualty losses, under IRC §2054, can be claimed as an estate tax deduction or as an estate income tax deduction under IRC §642.
IRC §2058 allows a deduction, in the amount paid, for death taxes — including estate, inheritance, legacy, and succession taxes — paid to a state or to the District of Columbia. However, the taxes must be paid no later than 4 years after filing the estate tax return, or later, if IRC §2058(b)(2) applies, i.e., petition for redetermination of a deficiency filed with the Tax Court, a grant of an extension of time to pay, or a claim for refund or credit of an overpayment.
Medical expenses can be deducted as an itemized deduction. However, only the portion of the medical expenses that exceeds 10% of adjusted gross income, or 7.5%, if the taxpayer or spouse is over 65, is deductible from income. Medical expenses can also be deducted from the estate tax under IRC §2053(b). If the estate is large, it may be more prudent to deduct it from estate taxes, since up to 40% of the expense can be deducted.
Trusts and estates are also subject to the net investment income tax, what is sometimes referred to as the 3.8% Medicare surcharge, based on the lesser of undistributed net investment income or the excess of adjusted gross income over the amount of the highest regular income tax bracket in effect for the year. Although the NIIT is adjusted for inflation for estates and trusts, but not for individuals, nonetheless, the NIIT is assessed at much lower income levels, which, in 2015, was $12,300.
Income distributed to a beneficiary is considered distributed in the same proportion as income earned by the estate or trust. So, if the estate earned 60% dividend income and 40% interest income, then any distribution to a beneficiary will also consist of 60% dividend income and 40% interest income. Income from IRA distributions is not counted as investment income. Distributions to beneficiaries are deductible by the estate.
Estate property generates $12,000 in cash, $10,000 of which is distributed to the residuary beneficiary. Therefore, the $10,000 distributed to the beneficiary is taxable to the beneficiary, and the remaining $2000 is taxable to the estate. The estate can deduct the $10,000 distributed to the beneficiary.
Valuation of Property Subject to Federal Estate Taxes; Alternate Valuation Date
The value of the estate is determined by the fair market value of the property when the decedent died or, under IRC §2032, on an alternate valuation date, which is 6 months after death. The election to use the later date must be made on the estate return, filed within 9 months of the decedent's death unless an extension has been requested. If a later date is used, then all property must be valued at that date. The purpose of allowing an alternate valuation date is to reduce the financial stress if estate property declines within that time, thus making it difficult to pay the estate tax.
However, any property that is distributed or disposed of within the 6 months must be valued on the date of disposition. Any property whose value would normally decline with the passage of time must be valued on the date of death. For instance, the present value of an annuity declines with each payment, so its value must be determined at the date of death, even if a later date is chosen for the rest of the estate.
If the alternate valuation date is elected for federal estate tax purposes, then the step-up or step-down in the basis for property will be based on their fair market value on the alternate valuation date. However, the alternate valuation date can only be chosen if the value of the entire gross estate is less at the later date than on the date of death, to prevent an executor from choosing a later date simply to receive a greater step-up in basis of the assets. Even if specific assets within the estate have increased in value, the later date can still be used if the value of the gross estate has declined.
Unified Transfer Tax Credit
Each individual is entitled to a unified tax credit that allows a certain amount of property—the exemption amount (aka exemption equivalent)—to be passed free of estate or gift tax. This amount can be doubled if the decedent leaves any unused portion of his estate and gift exemption to his surviving spouse. This so-called exemption portability has been made a permanent part of the tax code by the American Taxpayer Relief Act of 2012. Although most people think of the tax-free amount as being an exemption, the IRS actually calculates the exemption by granting a tax credit equivalent to the exemption. For instance, in 2003, the tax credit was $345,800, allowing $1,000,000 of property to be transferred tax-free.
The credit is described as unified because it is a lifetime credit that applies to gift, estate, and generation-skipping taxes. Each application of the credit during the taxpayer's lifetime reduces the credit. So if the taxpayer dies in 2015, and gave gifts valued at $1,117,800 during his lifetime that exceeded any annual exclusions, then only $1 million worth of the unified credit will be available to offset the estate tax on his estate property.
|Year||Unified Credit||Applicable |
Calculating the Estate Tax
The federal estate tax is imposed on the decedent's taxable estate, equal to the decedent's gross estate less deductions and other credits. Calculating the estate tax can be broken down into 4 steps: calculating the taxable estate, calculating the estate tax base, calculating the estate tax liability, and calculating the estate tax payable:
Taxable Estate = Gross Estate – Deductions (marital deduction, charitable contribution deduction, expenses and debts, losses, and state death taxes)
Estate Tax Base = Taxable Estate + Adjusted Taxable Gifts (post-1976 taxable gifts)
Estate Tax Liability = Estate Tax Base × Estate Tax Rate
Estate Tax Payable = Estate Tax Liability – Unified Credit – Post-1976 Gift Taxes – Credit for Taxes Paid on Prior Transfers – Credit for Pre-1977 Gift Taxes – Foreign Death Tax Credit
After the tentative tax is calculated based on the taxable estate, any credits—including the unified transfer tax credit—are subtracted to determine the payable tax.
Since the federal estate tax is a graduated, cumulative tax with a rate that depends on the size of the gross estate, the value of all post-1976 lifetime gifts that were above the annual gift tax exclusion for the year of the gift is added to the estate, including any gift taxes that were paid during the decedent's lifetime. This determines the size of the estate and the applicable tax rate. Hence, information must be obtained on all previous gifts where gift tax was paid, which can be obtained from the IRS by filing Form 4506, Request for Copy of Tax Return. Although paid gift taxes are added to the estate to determine the applicable tax rate, the estate can deduct the gift taxes paid so that taxes are not paid twice on any gift. Because the estate tax is a marginal tax, it is calculated like any marginal tax, in that income at each tax bracket is multiplied by the appropriate rate, then added. The current table, called the Unified Rate Schedule, can be found in the Instructions for Form 706.
|2013 - Indefinitely||40%|
|2011 - 2012||35%|
The gross estate includes property in the probate estate, nonprobate property, and any transfers where the decedent retained sufficient control or power over the property.
The estate tax is assessed on the fair market value (FMV) of the property at the time of death; thus, the beneficiaries of the estate receive the property with the tax basis equal to the assessed value of the property in the estate. This is often referred to as a stepped-up basis, because real estate and financial instruments do generally go up in value.
However, there is no step-up in basis if the decedent received the property as a gift from his spouse within 1 year preceding his death, and the property passes back to the donor-spouse as a result of the donee-decedent's death. This rule was passed to prevent a spouse from transferring property to an ill spouse expected to die soon, for the purpose of having the property transferred back to the surviving spouse so that it will receive a stepped-up basis.
If the decedent had a partnership interest, the decedent’s outside basis would be stepped-up, just as with other property, but the inside basis would not be stepped-up unless an election is made under IRC §754. Otherwise, any property sold by the partnership for gain, would be taxable to the estate of the deceased partner or to the beneficiary of the partnership interest.
If the decedent had community property and lived in a community property state, then only half the community property is includable in the estate. Additionally, only ½ of the debts can be subtracted from the value of the property. However, the property will receive a stepped-up basis, including the half owned by the surviving spouse. So, if properties were initially purchased for $70,000, and is worth $100,000 when 1 of the spouses dies, then the entire basis of the property will be equal to $100,000, so that the surviving spouse will have a stepped-up basis of $50,000 for her half of the property, and the other half will also receive a stepped-up basis of $50,000, whether or not gifted to the surviving spouse.
Starting February 29, 2016, the executor of an estate for a decedent who died on or after July 31, 2015 must report the basis of any property given to a beneficiary, to both the IRS and the beneficiary receiving the bequest.
Deductions include charitable gifts, debts, loans, and mortgages, funeral expenses, state death taxes, and the marital deduction. In broad outline, the estate tax is calculated thus:
- Determine the taxable estate, by taking the decedent's gross estate, which is the value of all property that the decedent owned or had a beneficial interest in, or retained control over at the time of death and certain transfers made within 3 years of the decedent's death, minus various deductions, such as death related expenses, debts, charitable deductions, state death taxes, and the marital deduction.
- Apply the tax rate on the decedent's taxable estate.
- Determine estate tax liability by deducting any credits, including the unified tax credit, with the result being the estate tax due.
Estate Tax = Taxable Estate × Tax Rate – Credits
The personal representative of the estate is liable for the tax. If there is an estate tax due, then the personal representative of the estate must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return with the Internal Revenue Service no later than 9 months after the death of the decedent. However, the personal representative can file Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes to automatically extend the time to file by 6 months.
Paying the Estate Tax; Filing Extensions
Estate taxes are due within 9 months after the decedent's death, but the personal representative can request an extension of up to 12 months from the due date of payment for a reasonable cause. In certain extraordinary circumstances, the IRS may also grant a series of extensions, up to a total of 10 years of necessary, from the due date of the original return.
Although the tax code does not define reasonable cause, it does give some illustrative examples: when a substantial portion of the estate consists of future payments for which the estate cannot borrow against, thus making it difficult to pay the estate tax; the estate does not have sufficient liquid funds to pay the tax while also providing for surviving spouse and dependent children, and the personal representative cannot generate enough cash from the assets to pay the tax; the estate has a substantial claim that requires litigation, so the outcome cannot be determined until later. As discussed later, the IRS will allow up to 14 years for the payment of a portion of the estate taxes if at least 35% of the adjusted gross estate consists of a business or farm.
Besides the 14-year payment period allowed for businesses and farms that compose at least 35% of the value of the estate, there are 3 other sections of the Internal Revenue Code that can provide some delay to pay estate taxes. Under IRC §6161, Extension of Time for Paying Tax, the payment period can be extended up to 2 years beyond the due date if the IRS finds that there is reasonable cause to grant extension. Under IRC §6159, Agreements for Payment of Tax Liability in Installments, the IRS can also allow installment payments if it is more likely to get paid. Under IRC §6163, estate taxes on reversionary and remainder interests in property can be deferred until 6 months after those interests terminate.
Tax that is deferred under IRC §§6159, 6161, or 6163 is assessed interest at the regular underpayment rate.
Under IRC §303, any gains realized from the redemption of stock to pay death taxes is not recognized as income. This may be especially beneficial if there are cross purchase agreements for a business in which the decedent owned an interest. The surviving owners purchase the stock of the deceased owner from his or her estate at fair market value. Any gain would be tax-free and can be used to pay the estate tax.
Tax Payments can be Deferred for Estates with Farms and Closely Held Businesses
Paying the estate tax may be a problem for the beneficiaries of farms and closely held businesses, since those assets are highly illiquid, and oftentimes, liquidating assets may impair the viability of the farm or the closely held business. The tax code contains several provisions that facilitate the payment of estate taxes. Under IRC §303, stock can be redeemed tax-free by a closely held corporation if the proceeds are used to pay estate taxes or expenses. Additionally, IRC §6166 provides 2 provisions facilitating the payment of the estate tax: allowing the estate tax to be paid by installments and to base the value of business property on its current use rather than on its most profitable use. To qualify for the deferred payment of estate tax:
- the value of the business must be at least 35% of the gross estate value
- the business must have 45 or fewer shareholders, and
- the decedent must have owned at least 20% of the business
Ownership interest by close family members can be added to determine the 20% test but only if it is for a capital interest in a partnership or stock of a private company. If the business interest is owned as community property, then the husband and wife are treated as 1 partner or shareholder. A rental property business can qualify under §6166, if the decedent actually managed the rental properties, by negotiating leases, supervising repairs and maintenance, and selecting or evicting tenants.
The IRS must be notified of any election under §6166 on or before the due date of the estate tax return, including extensions. The notice should state:
- the identity of the taxpayer
- the name of the business
- the amount of tax to be deferred
- the computation showing that the value of the business meets the minimum required.
Installment Payments of Estate Taxes
Estate taxes are generally due within 9 months of death, but if the value of the farm or closely held business exceeds 35% of the estate, then the executor can elect to pay some of the estate tax in installments over a maximum of 177 months. The percentage of estate tax that can be deferred because of a closely held business or farm is equal to its value divided by the adjusted gross estate. The remaining part of the estate tax must be paid by the due date, which is the estate tax attributable to the assets other than the closely held business or farm.
The minimum payment for the 1st 5 years must at least equal the interest assessed on the deferment of the tax payments; thereafter, the taxes must be paid in 2 to 10 equal annual installments. A reduced interest rate of 2% is charged on a portion of the estate, plus 45% of the underpayment rate, stipulated in IRC §6601(j)(1), on any balance. The limit on the 2% interest amount is equal to the lesser of the statutory limit or the estate tax minus the unified credit in the year when the decedent died. Any amount above the 2% limit would be assessed interest at the rate of 45% of the regular underpayment rate. The underpayment interest rate is changed quarterly and compounded daily. The statutory limit subject to the 2% rate is adjusted annually for inflation:
In determining whether 35% of the assets qualify for the estate tax deferral for a sole proprietorship, only those assets directly related to the business may be used to determine the threshold.
Interest must be paid annually and it is not deductible by the estate.
However, to defer interest, the IRS usually requires that a bond be posted, equal to twice the amount of the estate tax to be deferred. An IRS lien can be accepted instead of the executor's personal liability for a bond, but there are several requirements for the lien:
- the executor and all parties with an interest in the property must agree to the lien
- a person must be designated as an agent to represent the people who consented to the lien and to the estate beneficiaries
- the IRS may require additional lien property should the original property fall in value, to less than the amount of unpaid taxes plus the aggregate interest owed.
Additionally, the installment arrangement may be canceled by the IRS and demand the entire amount due, if:
- all or a significant portion of the business is disposed of
- required payments are not made within 6 months of the due date; or
- the estate has undistributed net income.
However, if the late payment is made within 6 months after the due date, then the remaining portion of the deferred estate tax can be paid in the remaining installments. Additionally, the regular interest rate on estate taxes will apply — not the reduced rate — and a 5% penalty on the late payment will be added.
For these reasons, the best means of paying estate taxes is by buying life insurance, since life insurance can provide enough liquidity to pay all expenses, debts, and estate taxes, and beneficiaries will receive their gifts sooner, since a final distribution to beneficiaries cannot be made until all estate taxes have been paid.
Current-Use Valuation (aka Special-Use Valuation)
When the IRS assesses the value of a former business, it will generally use a fair market value based on its most profitable usage. While this usually will not result in a problem for most businesses, farms may be hurt by this assessment, because the major asset of the farm is usually its land, and sometimes, the land will be more valuable if it were used as residential or commercial property. So if the heirs wanted to continue to use the farm or business, then the executor can elect to have the property based on its current use rather than the fair market value that was based on its most profitable usage. However, to ensure that the heirs truly do want to continue the business rather than just to lower their taxes, there are several requirements for current-use valuation:
- the decedent must have materially participated in the business for at least 5 of the last 8 years
- the property must pass to qualified heirs who must continue to materially participate in the business for at least 10 years afterwards
- the property must be used in the same way as when it received the special-use valuation
- the value of the property receiving the special valuation cannot be less than 25% of the total estate, and the combined value of the personal property and the real estate used in the business must exceed 50% of the gross estate
- the reason for this requirement is that there is a presumption that the estate would have enough liquid assets to pay the estate tax if the special-use valued property is a lower percentage of the estate
To ensure that the property is used for at least 10 years afterwards in its current use, the IRS registers a federal estate tax lien on the property. Furthermore, the reduction in value — the difference between fair market value and its current-use valuation — cannot exceed a certain limit, adjusted annually for inflation in increments of $10,000:
Tax Tip: Use Life Insurance to Pay Estate Taxes
In addition to the options above, a taxpayer or his beneficiaries can always purchase life insurance to pay estate taxes, thereby avoiding any liquidity problems. Many estates, especially those with farms or businesses, may not have sufficient liquid assets to pay estate taxes. In such a case, life insurance can be used to pay estate taxes. Because of the unlimited marital deduction, where assets can be transferred to the surviving spouse tax-free, the most common type of life insurance used to pay estate taxes is a form of survivorship life insurance, also known as second-to-die insurance, that pays only when the surviving spouse dies. Because at least one of the spouses will likely live to an old age, cash value life insurance is generally used: whole life, universal life, or variable life. These life insurance policies accumulate cash value and premiums do not increase with age. Furthermore, the premiums for survivorship life insurance are generally cheaper than for policies covering single individuals, because the premiums are paid over a longer period.
If the value of an estate is only marginally greater than the exemption amount, then the taxpayer can use several strategies to reduce the value of his potential estate, such as by making annual gifts that do not exceed the annual gift exclusion limit per individual or by using grantor retained annuity trusts. Most of these reduction strategies will take time, so, if the taxpayer is middle-aged or younger, term life insurance may be used during the reduction phase to pay any estate taxes if the taxpayer would die unexpectedly.
Another tax advantage can be gained by having an irrevocable life insurance trust, such as a Crummey trust, own the life insurance policy instead of the taxpayer — otherwise, the proceeds of the life insurance policy will be includible in the estate if the taxpayer has any incidents of ownership in the policy within 3 years prior to death.
- For 2010, a special rule allowed the executor to exempt the estate from the estate tax, but the basis of the estate property would equal the lower of the decedent's adjusted basis in the property or the property's FMV. However, a special rule was enacted that allowed the total basis to be increased by $1.3 million on all assets, and for property transferred to a surviving spouse, an additional $3 million basis could be added. However, the basis of any property cannot exceed its FMV.