Overview of Federal Estate & Gift Tax System

The federal gift tax applies to taxable gifts that you make during your lifetime. You, as the donor, are primarily liable for payment of the tax. The federal estate tax applies to property you own, or are treated as owning for federal estate tax purposes, at your death. As a practical matter, this tax is often paid by the estate rather than the beneficiaries. The estate and gift taxes work together as a system to reduce the transfer tax advantages of making lifetime versus post-mortem transfers and vice versa . The system accomplishes this goal by:

• applying the same graduated tax rate structure to both lifetime taxable gifts and property owned at death (due to the applicable credit amount, the marginal rate effectively begins at 41%, until 2004 when that rate rises);

• using a tax base for estate tax purposes that takes into account all lifetime taxable gifts you made as well as property you own, or are treated as owning for federal estate tax purposes, at the time of your death; and

• adopting a unified tax credit that can be used to reduce both estate and gift tax liability (sometimes referred to as the “applicable exclusion amount”).

Due to the unified credit (or “applicable credit amount”), if you have made no lifetime taxable gifts, you can pass a substantial amount of property or money to any beneficiary (or beneficiaries) without incurring federal estate tax liability. The amount is $1 million in 2003, and increases in stages up to $3.5 million by 2009. In addition, with proper planning, you may transfer an unlimited amount of property and or money to your spouse. Since these marital transfers can be structured so that they do not reduce the unified credit, with proper planning it might be possible to transfer $1 million or more (depending on the year) to nonspousal beneficiaries and the rest of your estate to your spouse without incurring any federal estate tax liability. Thus, when planning your estate it will be important to calculate with some precision the likely size of your estate and the extent to which you wish to allocate your estate between your spouse and other beneficiaries. This, in turn, will largely determine which planning techniques will work best for you as well as the extent to which the use of lifetime gifts would reduce your total tax liability.

Gift Tax:
Since the gift tax applies only to “taxable gifts,” not every gratuitous transfer is taxed. For example, taxable gifts do not include the first $11,000 of money or property that you give per donee per year, provided that the gift is of a present interest. This $11,000 amount is annually indexed for inflation. Thus, you can give $11,000 per year per donee ($22,000 for a married couple) without generating gift tax liability and without reducing the applicable credit amount. In addition, most gifts to your spouse are, in effect, tax free because they give rise to a marital deduction equal to the value of the gift. Finally, depending upon the facts, medical or educational expenses that you pay on behalf of others (such as your children or parents) are not subject to gift tax.

Estate Tax:
Since the marginal federal estate tax rates currently “kick in” at 41% (through the year 2003) when planning your estate it is very important to identify the nature and estimated value of all property that could be subject to the tax. Technically, all property that you own at death is subject to the tax, even though some of this property might not be included in what is known as your “probate estate” under state or local law. This includes life insurance, real estate, stocks, bonds, and your ownership interest in the business. In addition, other type of property may be treated as being owned by you at your death and thus subject to federal estate tax liability in your estate. An example of this type of property is property over which you have a general power of appointment, i.e., the power to appoint the property to anybody, including to yourself or to your estate. All property included in your estate, less certain deductions such as those for the value of qualifying transfers to a spouse, is ultimately aggregated with your lifetime taxable gifts (if any) to determine the federal estate tax liability. The applicable credit amount is then applied to reduce the amount of tax owed.
The complexity of the federal estate and gift tax system can present a number of potential pitfalls for the unwary. However, with proper planning, it is possible to ensure that your property is in fact distributed in accordance with your wishes and that your federal estate and gift tax liability is minimized. As a starting point, you and your spouse may find it helpful to compile a preliminary estimate of your assets that we can examine in more detail when we meet and give some thought as to how you might want those assets managed and/or distributed in the future.

Estate Tax Repeal in 2010:
The estate tax system is repealed with respect to decedents dying in 2010. The gift tax, however, would remain in place after that date.