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Previously taxed property credit.

Introduction

If an individual dies within 10 years of inheriting property, Sec. 2013 may offer some estate tax relief in the form of a "previously taxed property credit." This credit is designed to provide relief from estate taxes that would otherwise be payable when the same property is included in two decedents' estates within a relatively short period of time. However, the credit may also be available for some property that is taxed in only one of the estates.

Assume one spouse dies (H) and leaves property to a qualified terminable interest property (QTIP) trust, which is to pay income to the surviving spouse (W) for her life and then distribute the property to their children. If W passes away following H's death, but before his estate tax return has been filed, the executor of H's estate may be able to obtain a previously taxed property credit for W's estate (as well as obtaining tax savings by equalizing the two estates) by forgoing the Q TIP election. The general idea in this situation is that W has only a life interest in the property passing in trust to her on H's death. If the Q TIP election is not made, the property is taxed as part of H's estate. The value of this property is not included in W's estate; nevertheless, because W's life interest in the property has value at the time W dies, there is a credit available to W's estate (Rev. Rul. 75-550).

Because this credit can result in a substantial tax savings, it is almost always advisable for the tax professional to obtain an extension of time to file the estate tax return of the first spouse to die, and delay filing the return until close to the extended due date, to allow planning should the second spouse die prior to the filing of the return.

Discussion

A very common estate plan for a husband and wife with combined estates of more than $1.2 million is for the first spouse to die to leave property valued at $600,000 to a bypass trust and the balance of his estate to a Q TIP marital trust. On the death of the first to die, the executor will typically make a Q TIP election to have the property in the Q TIP trust qualify for the marital deduction. The effect of the Q TIP election is that the property in the QTIP trust will avoid estate tax in the deceased spouse's estate, but be subject to estate tax in the surviving spouse's estate at that death. Because the value of the property distributed to the QTIP trust is deductible in computing the amount of the deceased spouse's taxable estate, that property is not included in both taxable estates Should the surviving spouse die within 10 years after the death of the deceased spouse, however, there is no previously taxed property credit allowed in the estate of the surviving spouse.

If the property in the QTIP trust is instead taxed in the deceased spouse's estate and the surviving spouse dies within 10 years after the death of the deceased spouse, a potentially substantial, previously taxed property credit may be available in the surviving spouse's estate. This credit is based on the value of the surviving spouse's life interest in the property passing to the trust on which the QTIP election would otherwise have been made.

If a surviving spouse dies holding a life interest in property taxed in the deceased spouse's estate, the value of the life estate is usually calculated using the surviving spouse's age at the deceased spouse's date of death and applying the Sec. 7520 actuarial tables. This actuarial figure will usually apply even if the second spouse dies within days of the first spouse. There are limitations to the use of the tables, however; these were recently codified in Regs. Sec. 20.7520-3(b)(3), effective for transactions after Dec. 12,1995.

If at the time of the deceased spouse's death, the surviving spouse has an incurable illness or other deteriorating physical condition so that she has at least a 50% probability of dying within one year, the tables are not used to value the life estate (Regs. Sec. 20.75203(b)(3)(i)). (If the surviving spouse survives for 18 months or longer, the spouse is presumed not to have been terminally ill (Regs. Sec. 20.7520-3(b)(3)(i)).) However, if the second spouse dies soon after the first spouse from an illness, but was not considered to be terminally ill at the first spouse's death, the tables are still used. If both spouses die as a result of a common accident, the tables are not used, even if it can be shown that one spouse survived the other (Regs. Sec. 20.75203(b)(3)(iii)).

The previously taxed property credit is calculated using the Federal estate tax paid on the transfer of property (including property passing as a result of the exercise or nonexercise of a power of appointment) to the transferee by or from a person who dies within 10 years before or within two years after the transferee's death (Sec. 2013(a)). If the transferor predeceases the transferee by two years or less, the credit to the transferee's estate is the full amount of the calculated credit (Sec. 2013(a)); the amount of the calculated credit decreases by 20% every two years thereafter so that no credit is available if the transferor predeceases the transferee by over 10 years (Sec. 2013(a)).

The credit is the smaller of:

A. The amount of the Federal estate tax attributable to the transferred property in the transferor's estate, expressed as the following fraction:

Value of transferred property/Transferor's adjusted taxable estate

multiplied by the transferor's adjusted Federal estate tax; or

B. The amount of the Federal estate tax attributable to the transferred property in the transferee's estate (Sec. 2013(b) and (c);Regs. Sec. 20.2013-2(a) and -3(a)). See the comprehensive example on page 596.

RELATED ARTICLE: Comprehensive Example: Previously Taxed Property Credit

Husband H, age 70, predeceases wife W, age 65. W dies within two years of H's death The couple's combined estate is $2,000,000 and consists one-half of H's separate property and one-half of W's separate property.

Under a normal estate plan, $600,000 will be set aside in a bypass trust, and the balance of H's property ($400,000) will usually pass to a marital trust (on which a QTIP election will be made). No estate tax will be due at H's death, but at W's death approximately $800,000 will be subject to estate taxes of 5267,500.

Alternatively, if the estates are equalized and the previously taxed property credit is used, no QTIP election will be made on the marital trust, so that $400,000 will be taxed in H's estate. The resulting tax in H's estate will be approximately $120,000 and W's estate will use the previously fixed property credit.

The credit will be calculated as follows: 117 at age 65, has a life estate in the "non-QTIP" property worth approximately $260,000. (The property was valued at $400,000. Using 8.2%, the rate of return for 7/96, as 120% of the mid-term applicable Federal rate (AFR), the life estate factor under the tables is 0.6579: however, this is rounded to 65% for purposes of illustration.) The credit to W's estate will be $31,200 [($260,000 $1,000,000 X $120,000]. W's estate tax on $400,000 will be $120,000 less the $31,200 credit, for a total tax on H's and W's estates of $208, 800. Therefore, the total tax on H's and W's combined estates is $58,700 less than if the entire estate tax were paid by W's estate; $27,500 of the savings results from the use of both spouses' lower brackets and the remaining $31,200 of savings is due to the credit.

From Daniel E. Davis, Esq., and Deborah G. Corlett, Esq., O'Brien Watters & Davis, LLP, Santa Rosa, Cal.
COPYRIGHT 1996 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Article Details
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Author:Corlett, Deborah G.
Publication:The Tax Adviser
Date:Oct 1, 1996
Words:1350
Previous Article:Exclusion from estate for life insurance proceeds.
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