The government imposes gift and estate taxes on transfers of wealth during an individual's life and at death. At the federal level, the Internal Revenue Code governs gift and estate taxes, while individual state tax codes codify state estate tax laws.
The Gift Tax
The federal gift tax is set forth beginning in Section 2501 of the Internal Revenue Code (26 U.S.C. § 2501). Gift taxes are imposed on money or property transferred gratuitously by a donor to another individual or non-charitable organization during the donor's life. Not all gifts are subject to the gift tax. Typically, the gift tax is not applied to gifts between spouses and gifts made to qualified charities. Additionally, the federal gift tax exclusion allows a donor to give up to a certain amount in gifts each year without paying gift taxes. In 2006, the annual gift tax exclusion was $12,000. The annual exclusion applies to each person to whom a gift is made. Thus, a donor may give any number of people up to $12,000 without filing a gift tax return.
The Federal Estate Tax
The federal estate tax is set forth beginning in Section 2001 of the Internal Revenue Code (26 U.S.C. § 2001). Estate taxes are imposed at the time of the estate-holder's death. A person's taxable estate consists of all property owned by the estate-holder at death (known as the "gross estate") less allowable deductions. The gross estate may include real estate, stocks, bonds, business interests and personal property. If the estate-holder left a surviving spouse, the spouse's share of the property will be deducted from the gross estate. Deductions will also be taken from the gross estate for the estate-holder's funeral expenses, debts owed at the time of death, and property devised to a tax-exempt charity. Under the Economic Growth and Tax Relief Reconciliation Act of 2001, a certain portion of the taxable estate is exempt from estate taxes. The exemption amount for 2006, 2007 and 2008 is $2 million. Accordingly, estates worth less than $2 million are not liable for any estate taxes. For larger estates, however, the value of the estate over $2 million is taxed at rates starting at 39% and rising to 47%. The estate tax is scheduled to phase out by the year 2010, though the tax may be reestablished in 2011 unless the repeal is made permanent.
State Estate Taxes
A number of states impose estate taxes, often called "inheritance taxes," on estates that are not large enough to owe federal estate taxes. Like federal estate taxes, property left to a surviving spouse or to a tax-exempt charity may be exempt from state estate taxes.
Avoiding the Estate Tax
Many individuals engage in estate planning before death in an effort to reduce or avoid substantial estate taxes. The most popular estate planning tool is the trust. Funds placed in a trust are not owned by the estate-holder at death, and are therefore not subject to the estate tax.
Recipient Tax Liability
Recipients of an inter-vivos gift or a decedent's estate are not liable for gift or estate taxes on that property. Additionally, because property received by gift or inheritance need not be included in income, a recipient is not required to pay income tax on the value of the gift or inheritance received.