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.
