Credit for prior transfers can produce a significant reduction in estate tax.

The estates of decedents who received property from other decedents may be able to take a credit for Federal estate tax paid on the prior transfer. But the credit for prior transfers only applies to transfers that occurred within a specified period of time, and only to certain types of transferred property. This article examines property eligible for the credit and the complex rules regarding its computation.

Introduction

If a decedent receives property that was taxed in the estate of his transferor, Sec. 2013 allows a limited credit against his Federal estate tax liability based on the prior Federal estate tax paid on the transferred property, if the transfer occurred from 10 years before the decedent's death to two years after. The credit for prior transfers (CPT) is computed on Schedule Q of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return; the Form 706 instructions provide a worksheet. The CPT alleviates the inequity that would otherwise result if estate taxes were assessed on successive property transfers within a relatively short period of time.

Example 1: P died on June 1, 1996, leaving all of his property to Q.Q dies on Sept. 1, 1996, leaving all of his property (including the property inherited from P) to R. If Q's estate is not allowed relief from the two estate taxes otherwise paid (by P's and Q's estates), the value of the inherited property would be greatly reduced by Federal estate taxes. If the marginal estate tax rate in each case was 50%, the value of the property inherited by R would be reduced to 25% of the value of the property originally in P's estate.

This article will illustrate the CPT's operation and calculation, the types of transfers that qualify and planning issues involved in maximizing the CPT's value in an estate tax computation.

CPT's Operation

Under Sec. 2013(a), the CPT offsets all or part of the Federal estate tax paid with respect to the transfer of property (including property passing as a result of the exercise or nonexercise of a power of appointment) to a current decedent by or from a person who died within 10 years before, or two years after, the decedent. If the prior decedent ("the transferor") died more than two years before the current decedent, the CPT is reduced as follows:

* 20% if the transferor died within the third or fourth year preceding the decedent's death.

* 40% if the transferor died within the fifth or sixth year preceding the decedent's death.

* 60% if the transferor died within the seventh or eighth year preceding the decedent's death.

* 80% if the transferor died within the ninth or tenth year preceding the decedent's death.

For CPT reduction purposes, Regs. Sec. 20.2013-1 (c) defines "within" to mean "during"; thus, if a death occurs on the second anniversary of another death, the first death is deemed to have occurred within two years of the second death. The CPT may also be available if the transferor dies within two years after the current decedent. This can occur if the transferor transferred property to the decedent during his lifetime, but the property was later included in the transferor's gross estate because he retained some prohibited control over it.(1)

Example 2: N placed property in trust, retaining a life estate in trust income with the remainder to his daughter M or to her estate. M predeceased N by 18 months. The trust property is includible in both M's and N's estates because of the retained income interest, but the CPT will be available to M's estate.

Property Transfers

A CPT is available only if there is a "transfer" of property by or from the transferor to the decedent. According to Regs. Sec. 20.2013-5(b), this means any passing of property (or an interest in property) under circumstances causing the property to be included in the transferor's gross estate; property transfers eligible for the CPT include:

* Specific bequests.

* Transfers made pursuant to statutory spousal rights at death.(2)

* Transfers made to either a surviving joint tenant (under a joint tenancy) or to a surviving spouse (under a tenancy by the entirety).

* Transfers made to the beneficiary of life insurance proceeds.

* Transfers made to the survivor of an annuity contract.

* Transfers made to the donee of a general power of appointment.

* Transfers made to an appointee under the exercise of a general power of appointment.

* Transfers made to certain remainder interest holders who take property as a result of the nonexercise or release of a power of appointment.

The definition of "transfer" is very broad, and the above list is not all-inclusive; any passing of property or an interest in property qualifies as a transfer. For example, the amount paid to an heir in settlement of a genuine will contest is a direct "transfer" from the decedent to the heir and not a transfer to the heir from a third party. Therefore, the heir's estate can claim a CPT if all other requirements are met.(3)

What Is "Property"?

For CPT purposes, Sec. 2013(e) broadly defines "property" to include any beneficial interest in property, including a general power of appointment. Regs. Sec. 20.2013-5(a) includes as property annuities, life estates, estates for terms of years, vested or contingent remainders and other future interests. According to Regs. Sec. 20.2013-1(a), there is no requirement that the transferred property be identified in the decedent's estate or that it be in existence at the time of the decedent's death. A life estate received by the decedent from the transferor clearly illustrates this concept. Even though the value of a life estate is not included in a decedent's gross estate because it terminates at death, it is "property" for CPT purposes.(4)

Example 3: L inherits a life estate valued at $300,000 from her great-aunt. Estate taxes attributable to the life estate were $120,000. L dies 18 months later. The life estate is not includible in L's gross estate; however, L's estate is entitled to a $120,000 CPT because of the prior transfer.

In this example, all estate taxes may be eliminated in L's estate due to the CPT even though the life estate is not includible in her gross estate; however, generation-skipping transfer (GST) tax would still need to be considered on the expiration of the life estate. The CPT is not available with respect to GST taxes. Therefore, estate taxes can be reduced or eliminated, but if GST tax is assessed on the estate because the property generating the life estate goes to L's children, GST tax may still be assessed on the transfer.

In the case of outright asset transfers from the transferor (e.g., cash bequests), no tracing rule applies. The CPT will still be available in the decedent's estate tax computation even though he has consumed the cash bequest by his date of death. Under Regs. Sec. 20.2013-1(a), for CPT purposes, it is sufficient that the transferred property was subject to Federal estate taxes in the estate of the transferor and that he died within the prescribed time frame.

Regs. Sec. 20.2013-5(a) excludes from the term "property" (1) bare legal title, such as that held by a trustee and (2) a special power of appointment over property.

Example 4: G, a trustee, has a power to withdraw $5,000 a year from the trust for his enjoyment. Since this power is not a general power of appointment over trust property, a CPT is not available with respect to this property.

Example 5: The facts are the same as in Example 4, except that G has a general power of appointment over the trust property. The property will be includible in G's estate; thus, the CPT will be available for such property.

Valuation Issues

Sec. 2013(d) provides that, for CPT purposes, the value of property transferred to the decedent is th value at which the property was included in the transferor's gross estate. Regs. Sec. 20.2013-4(a) provides that, in the case of life estates, remainder interests or other limited interests in property, recognized valuation principles are to be applied as of the date of the transferor's death. Generally, this means that, regardless of the decedent's actual physical health at that time, IRS valuation tables (based on 120% of the Federal midterm interest rate for the month in which the valuation date falls) must be used.(5) However, if the decedent was terminally ill at the transferor's death, the valuation tables should not be used; instead, the computation should consider the actual life expectancy.(6)

Example 6: I inherited a life estate from J, a decedent. At the time of J's death, I had an incurable disease and could not survive J by more than one year; I's death actually occurred four months later. The IRS ruled the life interest to be only 1% of the value of the property in J's estate, while the actuarial tables would have ascribed 52% of the value of the property to the life interest.(7)

To generate a CPT, property must be capable of being valued using normal valuation techniques and have a value greater than zero.(8) Thus, the courts have found that the CPT is not available in life estate situations involving simultaneous deaths, because the life estate has no value in the transferor's estate.(9) Discretionary trusts can also present valuation problems; the Service has ruled that a life estate cannot be valued if the trustee has the absolute discretion to either pay out trust income to the income beneficiary or to accumulate it.(10)

The retention of broad administrative powers by a trustee can also raise valuation issues. In Holbrook,(11) the trustee's unfettered ability to invest in unproductive assets, hold cash and marketable securities with minimal yield and retain investments for possible appreciation made the decedent's income interest incapable of valuation at the date of the transferor's death, negating the CPT's availability. A similar result was reached when a trustee was given absolute discretion as to the amount of income to distribute to each of three income beneficiaries, one of whom was the decedent.(12) On the other hand, if the trustee's power to divert trust income away from the decedent is limited by a definitely ascertainable standard (e.g., health, education, support or maintenance) and the likelihood of such redirection of income is remote, valuation is possible, allowing a CPT.(13)

Example 7: A testamentary trust gives an independent third-party trustee the discretionary power to distribute income among three children. The income interest would not be able to be valued with respect to any of the three children, so that a CPT would not be available to the estate of a deceased child.

Example 8: A testamentary trust gives an independent third-party trustee the power to distribute income equally among three children. The CPT would be available to the estate of any of the children, because the income interest is capable of being valued.

The Service has also held that the CPT is available in the case of a residuary trust when the trustee's power to invade corpus for the decedent's or another beneficiary's benefit is limited by an ascertainable standard.(14) The absence of a definite standard limiting the trustee's discretion to make principal distributions will normally present an insurmountable valuation problem.

Example 9: A will provides for a credit shelter trust with income payable annually to the surviving spouse and a power in an independent trustee to invade corpus if necessary for that spouse's health, support or maintenance. Because the trustee is limited by an ascertainable standard, the residuary interest in the trust can be valued, allowing a CPT.

Computing the CPT

Before considering the percentage reduction, the CPT is limited under Regs. Sec. 20.2013-1(b) to the lesser of (1) the Federal estate tax attributable to the transferred property in the transferor's estate (the "first limitation") or (2) the Federal estate tax attributable to the transferred property in the decedent's estate (the "second limitation"). These computations are substantially different from one another.

Limitation #1

The first limitation is determined, under Regs. Sec. 20.2013-2(a), by multiplying the transferor's adjusted Federal estate tax by the ratio of the value of the transferred property to the transferor's adjusted taxable estate. This limit is computed using the average tax rate for the transferor's entire estate. In the event the CPT relates to property received from several different transferors, Regs. Sec. 20.2013-2(d) provides that separate credit computations must be made with respect to the property received from each transferor. Under Regs. Sec. 20.2013-2(b), the transferor's adjusted Federal estate tax is the Federal estate tax paid by his estate plus the credit for gift tax paid under Sec. 2012 (if any), plus the CPT allowed, but only if the transferor acquired property from a person who died within 10 years of the current decedent.

Sec. 2013(g) states that Federal estate tax does not include the additional estate tax paid on excess accumulations in qualified plans under Sec. 4980A(d). However, under Sec. 2013(f)(1), it does include any additional estate tax paid as a result of recapture under the Sec. 2032A special-use valuation rules, if the triggering event occurs within two years of the decedent's death.

In addition, the adjusted estate tax must be the amount of tax actually paid; consequently, if an extension of time to pay estate taxes under Sec. 6161 or 6166 is obtained, the first CPT limitation can only take into account the estate tax liability actually paid at the time the transferor's estate tax return was filed. The first limitation must be recomputed as additional installments are made by the transferor's estate. If the recomputation produces a larger CPT, the transferor's estate can file a refund claim.(15)

For CPT calculation purposes, the value of the property transferred is the value at which the property was included in the transferor's gross estate (decreased by certain specified reductions); the value of the property at the date of the decedent's death is irrelevant.(16) Reductions include the following:

* Death taxes (e.g., Federal estate tax and any other estate, succession, legacy or inheritance tax) payable out of property transferred to the decedent or payable by the decedent in connection with the property transferred to him.

* Any encumbrance on the property or any obligation imposed by the transferor on the decedent as a result of the transfer.

* The amount of the marital deduction allowed to the transferor's estate if the decedent was the transferor's surviving spouse at the time of his death.

The last reduction generally makes the CPT unavailable when the decedent has inherited property as a surviving spouse. Under Sec. 2013(f)(2), if the two-year Sec. 2032A recapture rule (previously discussed) applies, special-use valuation is completely disregarded for property valuation purposes. In addition, if the property transferred consists of all or a portion of the residue of the transferor's estate, some or all of the estate administrative expenses will reduce the value of the property transferred; even administrative expenses claimed as income tax deductions under Sec. 642(g) may serve as reductions.(17)

Example 10: J inherits the family farm from her father, F, who had inherited it from his father (i.e., J's grandfather) five years before. J's grandfather's taxable estate was large enough to generate estate tax; the CPT in F's estate from the transfer was $30,000. The value of the farm in F's estate was $120,000. The value of F's estate was $1,000,000; the estate tax paid was $123,000. For purposes of calculating the first limitation, the tax paid in F's estate would be increased by the CPT to $153,000 ($123,000 + $30,000). The limitation would then be calculated as follows:

$120,000 / $1,000,000 X $153,000 = $18,360

Limitation #2

The second limitation, under Regs. Sec. 20.2013-3(a), is the estate tax paid attributable to the value of the transferred property (i.e., the amount by which the decedent's estate tax payable (without regard to the CPT) exceeds the tax that would be payable by his estate (without regard to the CPT) if the value of the transferred property were excluded; thus, this limit is calculated at the marginal tax rate for the decedent's estate. If the credit for a particular foreign death tax may be taken under either the Code or a death tax convention and is taken under the latter, no foreign death tax credit may be taken into account in calculating the second limitation.

If the decedent's estate is entitled to a charitable deduction, the estate tax on the reduced estate must be calculated with a diminished charitable deduction. Under Regs. Sec. 20.2013-3(b), the charitable deduction in the decedent's estate must be reduced based on the proportion of charitable property transferred to the estate. This downward adjustment presumes that the charitable transfer will be paid in part from the transferred property; as a result, the CPT should be partially disallowed. The mandated charitable deduction adjustment sharply contrasts with the treatment of the marital deduction. The IRS has ruled that no marital deduction adjustment need be made in determining the estate tax payable when the value of the transferred property is excluded from the decedent's estate.(18)

Example 11: S inherited stock from his mother, M, within two years of his death. S's will provides that one-third of his estate after payment of administrative expenses is to go to a qualified charity. The stock inherited from M comprises 25% of S's gross estate. The charitable deduction in the estate must be reduced by 25% (the value of the previously taxed property deemed to be transferred to charity) when calculating the estate tax on the estate less the transferred property.

If the CPT relates to property received from multiple transferors, the property received from all of the transferors must be aggregated to properly determine the second limitation. Regs. Sec. 20.2013-3(c) provides that the overall limitation so determined must then be apportioned to the property received from each transferor in the ratio that the property received from each transferor bears to the total of all property received from all transferors.

These apportioned amounts make up the second limitation with regard to each transfer and are compared to the first limitation on the same transfer. Sec. 2013(a) requires the smaller of these two limitation amounts to be multiplied by the appropriate percentage reduction factor based on the time span between the decedent's death and that of the specific transferor involved. The CPT allowed is the sum of the separate credits so determined.(19) See Example 12 below.

Planning Opportunities

The CPT can make a significant reduction in the taxes paid by the estate of a recipient of prior transfers. The executor and/or estate tax return preparer may find it difficult to establish whether the decedent was the recipient of prior transfers if their presence was not ascertained while the decedent was still alive. A question concerning the amount and nature of any bequests received as part of the information gathered when preparing annual income tax and gift tax returns will help document transfers in a timely way so that full advantage can be taken of any available CPT. All relevant information should be gathered timely and maintained in a file that can be referred to when the estate tax return is being prepared.

The CPT can be used to pass property to a younger generation free of estate tax as long as there is sufficient flexibility in the will to allow the executor to take advantage of the CPT in conjunction with a qualified terminable interest property (QTIP) provision. Because the executor can elect QTIP status for all or a portion of the property that would otherwise qualify for the deduction, property can be left out of the QTIP election in an amount sufficient to fully use both the unified credit and any CPT available to the estate.

If a will provides that after an amount sufficient to fund a credit trust is set aside, the remainder is to pass to the surviving spouse (either directly or in trust), then a disclaimer by the surviving spouse may be used to take advantage of the CPT. This allows property from the estate of the decedent spouse to pass to children free of any estate tax. If the will provides for other disposition of the property in the event that the surviving spouse disclaims, income from the property may still be available for use by the surviving spouse.

Example 13: D's will provides that in the event his surviving spouse disclaims any of the marital property, it is to pass to a credit trust. Income from the credit trust is payable at least annually for the benefit of the surviving spouse, and on the surviving spouse's death, the remainder passes to the children.

Conclusion

When used properly, the CPT allows property to pass to a younger generation tax-free. An estate planner should make clients aware of the CPT and help them plan to fully use it. An awareness that property has transferred to a client and documentation of the inherited property are essential. Expected inheritances should be taken into account during the estate planning process and estate plans should provide the flexibility necessary to fully use any available CPT.

(1) For example, under Sec. 2036, inclusion can result from the transferor's retention of possession, enjoyment or the right to income from transferred property.

(2) Such rights have replaced dower and courtesy interests in many jurisdictions; transfers pursuant to such interests are also treated as "transfers."

(3) See Est. of Lorraine A. McGauley, 61 TC 350 (1973), aff'd, 504 F2d 1030 (2d Cir. 1974)(35 AFTR2d 75-1581, 75-1 USTC [paragraph]13,043).

(4) Rev. Ruls. 59-9, 1959-1 CB 232, and 70-292, 1970-1 CB 187.

(5) See Secs. 1274(d) and 7520.

(6) See Prop. Regs. Sec. 20.7520-3(b)(3)(i). An individual who is known to have an incurable illness or other deteriorating physical condition is "terminally ill" if there is at least a 50% probability that he will die within one year.

(7) See Rev. Rul. 66-307, 1966-2 CB 429.

(8) Rev. Rul. 67-53, 1967-1 CB 265.

(9) See, e.g., Old Kent Bank and Trust Co., 292 F Supp 48 (W.D. Mich. 1968)(22 AFTR2d 6140, 68-2 USTC [paragraph]12,568), rev'd and rem'd on other issues, 430 F2d 392 (6th Cir. 1970)(26 AFTR2d 70-6025, 70-2 USTC [paragraph]12,703); Est. of Andrew P. Carter, E.D. La., 1989 (90-1 USTC [paragraph]60,003).

(10) Rev. Rul. 67-53, note 8.

(11) Jane W. Holbrook, 575 F2d 1288 (9th Cir. 1978)(42 AFTR2d 78-6419, 78-2 USTC [paragraph]13,249).

(12) Est. of Shirley Pollock, 77 TC 1296 (1981).

(13) Rev. Rul. 70-292, note 4.

(14) Rev. Rul. 75-550, 1975-2 CB 357.

(15) See Rev. Rul. 83-15, 1983-1 CB 224.

(16) See Regs. Sec. 20.2013-4(a).

(17) Rev. Rul. 66-233, 1966-2 CB 428.

(18) Rev. Rul. 90-2, 1990-1 CB 169.

(19) See Rev. Rul. 73-47, 1973-1 CB 397.