Estate Taxation - An Overview

The federal and state governments, including Vermont, have adopted various systems for taxing the transfer of wealth.  Under these systems, transfers which occur during life (see the Lifetime Gifts webpage) and at death are subject to taxation.  The estate and gift transfer tax systems are "unified," which means that gifts made during life can affect the amount of tax due upon death (see The Federal Estate Tax System, below).

Generally, the tax is imposed on the value of assets transferred, less certain deductions and expenses, and subject to certain credits.  Like income taxes, the transfer taxes are graduated, so that larger estates pay taxes at a higher overall rate than smaller estates -- in fact, many smaller estates pay no transfer taxes at all.  Estate taxes are paid by the estate, and not the recipient.

The Federal Estate Tax System

The federal estate tax system begins with the concept of the "gross estate."  Simply put, the gross estate consists of all property, real or personal, tangible or intangible, wherever situated in which the decedent had an interest at the time of his or her death.

Aside from the obvious property interests, the gross estate includes the following:

(1)    Life insurance which the decedent owned, or had any incidences of ownership in;
(2)    Property in which the decedent retained a life estate;
(3)    Certain transfers made within three years of death;
(4)    Transfers effective at death;
(5)    Annuities; 
(6)    Pension assets (including IRA's); and
(7)    Property over which the decedent had a general power of appointment at the time of death.

Property included in the gross estate is valued at the date of death (although an election may be available for an alternate valuation date.

Once the gross estate is determined, certain deductions are permitted.  The most common deductions are for transfers to the decedent's spouse (see Marital Deduction, below), transfers to charity (see Charitable Deduction, below), state estate taxes paid, the decedent's debts, funeral and burial expenses, and the expenses of administering the estate (attorney and accountant fees, executor fees, etc.).  The gross estate minus these deductions is known as the "taxable estate."

If the decedent made taxable gifts during life, these gifts are added back to the estate before calculating the tax (this is one way in which the estate and gift transfer tax systems are unified).  The estate tax is calculated on this total amount, using a graduated tax schedule which for 2019 and beyond starts at a rate of 18% for estates below $10,000, and quickly rises to a rate of 40% on estates in excess of $1,000,000 (2019 rate table).  The same tax rate applies to gifts (another unifying feature of estate and gift taxation). 

Once the estate tax is calculated, certain credits are allowed.  Each individual is allowed a unified credit which can be applied to transfers made both during life and at death (again, unification of the tax systems).  In 2019, the unified credit is $4,505,800 (which effectively means that estates of $11.4 million or less are not subject to estate tax). 

A key aspect of the federal estate tax is that the unified credit is "portable." This means that a husband and wife each have a credit of $11.4 million, for a total of $22.8 million. To the extent that the credit of one spouse is not used (at the first spouse's death), the survivor may use the unused credit to shelter his/her estate (known as "portability").

A credit is allowed for foreign death taxes paid.  Finally, a credit is allowed for taxes paid on gifts which were added back to the estate before calculating the estate tax (the last step in unification).

The Vermont Estate Tax System

Vermont imposes a state estate tax regardless of whether there is a federal estate tax imposed.  Under this new system, for Vermonters dying on or after January 1, 2016, estates in excess of $2.75 million are subject to tax (this exemption has been raised -- see below).  The tax is assessed at a flat rate of 16% of any estate valued over $2.75 million.  Unlike the federal system, only taxable gifts made within 2 years of the date of death are included in the estate (and subject to tax). 


The exemption was recently raised (June, 2019) so that for Vermonters dying on or after January 1, 2020, estates in excess of $4.25 million are subject to the 16% flat tax.  On or after January 1, 2021, the exemption rises to $5.0 million.  With proper planning a married couple will be able to shelter $10 million from Vermont estate tax starting in 2021.

Unlike the federal estate tax system, Vermont does not permit the portability of credits.


The Marital Deduction - QTIPs


For a married person, a major estate tax benefit is the ability to transfer assets to his or her spouse free of estate (or gift) taxation.  Any property transferred to a spouse, whether during life or at death, is deductible from the gross estate prior to the calculation of the estate tax.  This deduction is often the principal focus of estate plans involving married couples.  Transfers may be made outright, or in a trust known as a QTIP.

"QTIP" is an acronym for "qualified terminable interest property."  A QTIP is a special type of transfer from one spouse to another that allows the transferring spouse to attach strings to the transfer while still preserving the marital deduction.  A transfer will qualify as a QTIP if, at a minimum, the spouse receiving the property receives all of the income from the property during his or her life.  This permits the transferring spouse to direct how the property (the principal) will ultimately be disposed of.  For example, a husband can transfer property to his wife, and provide that she will receive the income for her life, with the property passing to their children at the wife's death -- this transfer will qualify for QTIP treatment, and the marital deduction for estate tax purposes.

In most cases, a living trust is used to make a QTIP transfer.  In the above example, the trust could further authorize the trustee to make distributions of principal to the wife, if needed.  The wife could also be given a limited (or unlimited) right to withdraw principal.  Therefore, a QTIP can be molded to fit almost any estate planning need while maintaining the estate tax benefit of the marital deduction.

At the death of the surviving spouse, any QTIP assets held for his or her benefit are included in the surviving spouse's estate and subject to tax.

The Charitable Deduction

Another method for reducing estate taxes is through the use of a charitable deduction.  The value of property which is left to a charity through a decedent's Will, trust or otherwise, is deductible from the decedent's gross estate.  Gifts to charities can be outright, or can be made by utilizing a charitable trust (see the Charitable Trusts webpage). 

Keep in mind that a deduction is allowed only for gifts made to a "charity" -- a term which has a very specific meaning under the Internal Revenue Code.  Some organizations which are not-for-profit may not qualify as a charity for estate tax purposes.  You should therefore check the status of any organization named in your estate plan if the resulting charitable deduction is part of your planning.  Similarly, your estate plan should provide for one or more alternate charitable beneficiaries in case your primary beneficiary ceases to exist or loses its status as a charity. 

Generation Skipping Transfer Taxation

As if the taxes discussed above are not enough, the federal system imposes yet another tax on transfers which "skip" a generation.  The theory of the generation skipping transfer tax (or "GST") is that if (for example) a grandparent transfers assets to a grandchild (known as a "skip person"), the estate tax that would have been imposed on the middle generation (i.e. the grandparent's child) is lost.  To recoup this tax, the GST is imposed on any transfer (not necessarily from grandparent to grandchild) which skips a generation.  For 2019 and beyond, the GST is imposed at the highest marginal estate tax rate (40%), and is in addition to the estate tax levied on the same transfer.  Where both taxes apply, the resulting tax can exceed 50%.

Some relief is afforded under the GST rules.  First, each individual is permitted to transfer up to $11.4 million to "skip" persons without the imposition of the GST (2019).  Therefore, the GST affects only larger estates.  Second, during life, an individual can gift up to $15,000 per year/per skip person without incurring GST (see the Lifetime Gifts webpage).

To put it mildly, GST planning is very complicated.  There are many rules governing the use of trusts, the assignment of generational levels, the application of the $11.4 million exemption, etc. which make the GST one of the most difficult areas of tax law.

If you have any questions regarding Estate Taxation or any aspect of the estate planning process, please  contact Richard W. Kozlowski, Esq. at (802) 864-5756 or by e-mail.