The federal tax system consists of three components�gift taxes, estate taxes, and generation-skipping-taxes. The federal estate and gift taxes are separate tax systems imposed on different types of transfers, but the systems are unified with respect to tax brackets and tax base (see table 11-1). The generation-skipping transfer taxes are separate taxes applied under different rules in addition to any applicable estate or gift taxes.

Federal gift taxes will apply only if both of the following two elements are present:

The essential elements of a taxable gift reveal some noteworthy facts. First, only property transfers are subject to gift taxation. Thus, the transfer of services by an individual is not a taxable gift. Second, the taxation of a transfer does not require an element of donative intent; simply, a transfer must be made for less than full consideration.

Certain transfers are exempt from the gift tax base by statute. First, a transfer of property pursuant to a divorce or property settlement agreement is deemed to be for a full and adequate consideration under some circumstances. Second, transfers directly to the provider of education or medical services on behalf of an individual are not taxable gifts to the recipient of the services. Finally, gifts that are disclaimed by the donee in a qualified disclaimer are not treated as taxable gifts.

Much of the planning and complexity associated with gift planning involves the annual exclusion. Qualifying gifts of $10,000 or less may be made annually by a donor to any number of donees without gift tax. The exempt amount can be increased to $20,000 if the donor is married and the donor�s spouse elects to split gifts on a timely filed gift tax return. After 1998 the exclusion amount will be indexed to inflation and will increase in $1,000 increments.

To qualify for an annual exclusion, the gift must provide the donee with a present interest. Outright interests or current income interests in a trust will provide the beneficiary with a present interest. Trust provisions providing the beneficiaries with current withdrawal powers can be used to qualify gifts to a trust for an annual exclusion even if the trusts provide for deferred benefits. Use of the annual exclusion in the transfer of life insurance products is discussed below.

Two types of gifts are fully deductible from the transfer tax base. First, the marital deduction provides that unlimited qualifying transfers made by a donor to his or her spouse are fully deductible from the gift tax base. The marital deduction will prove quite useful if it is necessary to rearrange ownership of marital assets in the implementation of the estate plan. This deduction is similar to the marital deduction against federal estate taxes discussed later.

The charitable deduction provides that qualifying transfers to a legitimate charity will be deductible against the gift tax base. Thus, all qualifying donations will avoid gift tax.

A cumulative credit of $192,800 was available against federal gift tax due on taxable transfers before 1998. The amount of this credit is being increased to $202,050 for 1998 and will be increased further according to the schedule in table 11-2. Under the unified nature of the federal estate and gift taxes, this credit provides a dollar-for-dollar reduction of transfer tax otherwise payable against taxable transfers either during lifetime or at death or both. The 1998 credit of $202,050 can be used against each dollar of transfer tax until it is exhausted. The tax credit of $202,050 is equivalent to an exemption of $625,000 of taxable transfers from the federal estate or gift tax. Previously, the credit was often casually referred to as the $600,000 unified credit. Since for 1998 no taxes are due on transfers until aggregate transfers by the donor have exceeded $625,000, the first tax rate bracket applicable to a transfer actually subject to tax is 37 percent. (Discussion of the unified credit continues below.)

The most difficult task in calculating the estate tax is often determining the assets included in the decedent�s estate tax base. Some of the included assets are obvious, such as individually owned property. But the estate tax rules often cause the inclusion of property in surprising circumstances. For example, property previously transferred by a decedent can be brought back to the estate tax base by provisions of the statute.

The starting point in the federal estate tax calculation is determining the property included in the decedent�s gross estate. It includes the property in the probate estate, which is all property that passes under the deceased�s will or, in the absence of a valid will, under the state intestacy law, but it also includes property transferable by the decedent at death by other means. The gross estate of the decedent includes the following:

As this list indicates, the gross estate of the decedent is defined much more broadly than the probate estate, and the reduction of just the probate estate will often have very little effect on the size of the federal estate tax paid.

Certain items are deductible from the gross estate for estate tax calculation purposes. First, legitimate debts of the decedent are deductible from the gross estate if these debts are obligations of the gross estate. Second, reasonable funeral and other death costs of the decedent are deductible from the gross estate. Third, the costs of estate settlement such as the executor�s commission and attorney fees are deductible to the extent such fees are reasonable.

Marital Deduction. As with the gift tax, qualifying transfers to a surviving spouse are deductible under the marital-deduction rules. Since the marital deduction is unlimited, the usual dispositive scheme (100 percent to the surviving spouse) for married individuals will result in no federal death taxes for a married couple until the death of the survivor of the two spouses. As a client�s wealth increases, sophisticated planning is needed to make optimal use of the marital deduction. Planning for the marital deduction for life insurance proceeds will be discussed later in this chapter.

Charitable Deduction. As discussed earlier, the federal estate tax charitable deduction provides that transfers at death to qualifying charities will be fully deductible from the estate tax base. The charitable deduction is an excellent device to reduce the gross estate of a wealthy individual.

The unified credit discussed above with respect to gift taxes is similarly applicable to transfers occurring at death. If the unified credit has not been exhausted to shelter lifetime gifts, it is available against transfers made at the death of a decedent.

The state death tax credit provides a dollar-for-dollar reduction (with certain limits) against federal estate tax due for any state death taxes paid by the estate. The state death tax credit is limited, and the maximum state death tax credit available to a particular estate is provided for by a progressive rate schedule in the federal tax code. The size of the credit against the federal estate tax is equal to the lesser of the state death tax actually paid or the maximum state death tax allowable under the progressive credit schedule. State death taxes are usually equal to at least the maximum state death tax allowable under the federal estate tax rules.

The GSTT was created by the Tax Reform Act of 1986. Its purpose is to prevent the federal government from losing transfer tax if a transferor attempts to skip one generation�s level of transfer tax by transferring property to a generation more than one generation below the level of the transferor (for example, a grandparent makes a gift of property to a grandchild). Although the GSTT is designed to prevent a transferor from finding a transfer tax loophole in the federal estate and gift tax systems, it is different from the unified estate and gift tax system in many ways. The GSTT is applied at a flat rate equal to the highest current estate or gift tax bracket on every taxable generation-skipping transfer. Thus any taxable transfers will be currently subject to a 55 percent rate if the GSTT applies. This GSTT is applicable in addition to any estate or gift tax that might otherwise be applicable to the transfer. Thus if the GSTT applies, a transfer could easily be subject to a tax rate in excess of 100 percent of the value of the asset transfer.

The GSTT applies to three different types of transfers. First, the GSTT applies to a direct skip that is an outright transfer during life or at death to an individual who is more than one generation below the transferor. The direct skip gift tax applies only if the parents of the skip beneficiary are alive at the time of the direct skip.

The GSTT is also applicable to a taxable distribution. A taxable distribution is a distribution of either income or principal from a trust to a person more than one generation below the level of the trust grantor. The recipient of the taxable distribution is a skip beneficiary of the trust. Thus, a taxable distribution can occur when a trustee makes a distribution to a skip beneficiary even if a nonskip beneficiary still holds a current beneficial interest in the trust.

Finally, a taxable termination is also subject to a GSTT. A taxable termination occurs when there is a termination of a property interest held in trust by death, lapse of time, or otherwise, and a skip beneficiary receives the remainder interest outright in the trust.

There is a cumulative $1 million exemption (inflation indexed after 1998) against GSTT for all generation-skipping transfers of an individual. The exemption can be applied against transfers during life or at death. A married individual can split gifts and make up to $2 million total of generation-skipping transfers without GSTT. The exemption should be affirmatively allocated to specific transfers in the gift or estate tax return of the transferor. Otherwise, the GSTT rules provide a default mechanism for allocating the exemption to transfers at an individual�s death, which will often result in less than optimal use of the exemption.