The “estate” is central to our professions. We plan estates, we administer estates and we even call ourselves trusts and estates practitioners.
But what’s this thing called the estate? How does its definition impact advice to clients and their understanding of their assets and how they pass? The concept of “estate” has different meanings in various technical contexts, which alone or collectively may not reflect clients’ understanding of their individual circumstances.
The changes of the American Taxpayer Relief Act of 2012 in the federal estate tax law, increasing the exemption to $5.25 million and allowing a surviving spouse to claim the unused exemption of a decedent, create broad opportunity to individualize planning and administration to the unique circumstances presented. Subtle differences in various meanings of a common term like “estate” become important for professionals to use in obtaining benefits available for clients and their heirs. The differences typically have a purpose that can impact either the taxes imposed or the property passing to the beneficiaries.
Federal Estate Taxes
For federal estate tax purposes, the Section 2033 of the Internal Revenue Code defines a decedent’s “gross estate” as “the value of all property to the extent of the interest therein of the decedent at the time of his death,” and then expands the gross estate to include several items such as lifetime transfers, life insurance and property subject to appointment. See IRC 2031 to 2046, generally. The estate tax estate is then refined to the “taxable estate” through the allowance of deductions. The Treasury Regulations even contain a definition of “adjusted taxable estate” for determining the credit of tax on prior transfers under IRC 2013.(see Treas. Regs. 20.2013-2(c)).
State Death Taxes
When states impose their own death taxes (19 states at last count), these basic concepts may be varied even further. Many states have a so-called SOP tax or pick-up tax, which imposes an estate tax equal to the federal credit for state death taxes paid prior to the 2001 repeal of that credit. These states may create a gross or taxable estate determined on the basis of the law as it existed in 2001. A peculiar example is Estate of Stevenson, 23 N.J. Tax. 583 (2008), in which New Jersey included in the taxable estate of a 2005 decedent phantom federal estate taxes that would have been paid if the decedent had died in 2001, even though no federal estate tax was in fact payable in the year of death. A state will usually exclude from its estate and inheritance taxes real property and tangible personal property located out of state. But then, inheritance tax statutes usually aren’t based on the federal estate tax, and they can contain even more varied rules. For instance, New Jersey imposes its inheritance tax on gifts made within three years of death, while it exempts life insurance passing under a beneficiary designation.
The Probate Estate
These broad definitions of the estate typically exceed the assets subject to the jurisdiction of the local probate court when it issues letters to a personal representative, executor or administrator to administer the estate. The so-called probate estate will only include property that stood in the name of the decedent and won’t include property passing by beneficiary designation, such as life insurance or retirement accounts, or by right of survivorship, such as joint bank accounts, real estate owned jointly by spouses, or accounts designated to be transferred at death. The probate estate may also be refined further. The commissionable estate upon which the personal representative is allowed compensation may be smaller than the probate estate, and exclude items such as specific bequests, or it may even be larger if the personal representative is required to render significant services, such as the settlement of estate taxes, with respect to non-probate assets. But, the executor may, nonetheless, be able to impact assets outside the probate estate. Indeed, even though the court appointed representative may not be entitled under state law to possession of all of the property included the estate for federal estate tax purposes, he’s the person entitled to file the federal estate tax return and to make elections that may impact the taxation of assets that he doesn’t control, such as a qualified terminable interest property election to qualify for the marital deduction or the portability election to allow the surviving spouse to claim the benefit of the deceased spouse’s unused federal exemption.
The Income Tax Estate
The income tax also has its own definition of an “estate,” which typically begins at death. The income of the estate as a separate taxpayer includes only the income derived from the property that the fiduciary of the estate is entitled to collect. Property passing by operation of law directly to an heir never becomes part of the income tax estate. Revenue Ruling 59-375, 1959-2 CB 161 provides an interesting example of this principle, excluding from an estate’s gross income the proceeds of real estate that passes automatically in intestacy under state law.
But, income tax concepts don’t always fall neatly into the probate estate. Even when assets pass directly to a beneficiary so that they never become part of the probate estate and don’t generate income taxable to the fiduciary estate, the estate may nonetheless impact the income taxes imposed. Income in respect of a decedent (IRD) under IRC 691 is income earned by the decedent during life, but not received until after death, so that the income taxes remain due, without regard to any basis step up for capital gains tax purposes under IRC 1016. The classic example is a retirement account. To avoid the double burden of both the estate tax and the income tax, an income tax deduction is allowed for the federal estate tax attributable to the IRD each year it’s taken into income, causing estate tax concepts to apply to the income tax treatment of IRD.
The Client’s Estate
Of course, for most clients, these distinctions mean little. Clients take a much more pragmatic view of their estates. Sometimes, it will be a very narrow view, limited to the cash in the bank, so that the client is surprised to be worth more dead than alive, once the retirement accounts, life insurance and real estate are counted. Other clients may take a broad view of assets to consider in their estate plan that don’t fit any of these definitions.
If the client is a beneficiary of one or more trusts created by others, the trust may be subject to a power of appointment allowing the client to designate by will who gets the property. Or, the trust may pass without direction to specified remainder beneficiaries. In either case, the trust assets and their beneficiaries may be compelling for the client to consider in developing the estate plan, even though they’re not within any of the technical definitions of estate.
And clients may focus more on specific assets than on the estate as a whole, giving priority to the preservation and transfer of legacy property, whether it be a house, farm, business or artwork. Individual assets and their relationships with specific beneficiaries will have stronger emotional meaning for clients developing plans than any technical meaning outlined above. For many clients, the plan is to align these emotions with specific beneficiaries, be they spouses, children, significant others, extended family members, friends or charities. Emily Dickenson may have best captured this basic human need when she wrote in a letter in 1859 “My friends are my estate.”